News in Charts: Are higher rates hitting credit demand and supply?

With inflation at its highest in decades it seems an opportune moment to examine how central banks try to tame it. Their primary tool ‒ raising interest rates ‒ reduces inflation by slowing down the demand for and supply of credit. Higher rates discourage new borrowing and make existing debt more expensive, displacing resources away from consumption and investment, to ultimately cool down an overheated economy. However, micro-managing credit demand and supply through changes in rates is a tricky business, and going in too hard can threaten to destabilise the economy. The question that this research note explores is whether the ongoing hiking of rates has reduced credit demand and supply; and, if yes, are there any signs flashing red?

Indeed, in terms of demand for credit, the needle is moving down. Recent surveys point to weaker household intentions of making large purchases.

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The switch in household habits is clear enough, and has been priced in by equity markets. Consumer staples lost a lot of their appeal during COVID-19 lockdowns and the change to working from home. During that period, discretionary products were more popular, as stuck-at-home consumers were spending more on non-essentials. However, from the start of 2022 and with inflation increasingly eroding real incomes, people started switching back to buying essentials and discount products while delaying larger, discretionary product purchases.

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With households trading down, businesses have fewer reasons to invest, especially in an environment of high borrowing costs. A barometer of what their actual plans are in light of the credit-consumption dynamics is provided by the survey of the US’s largest small-business trade federation, NFIB. In October 2022, few US corporates (23%) claimed that they were planning significant capital expenditures over the next three to six months. That was down 8% from a year ago — a notable reduction, but no larger than the fall recorded during the COVID-19 lockdowns and the Global Financial Crisis (GFC). Taken together, recent rate hikes appear to have curtailed demand for credit, both from households to consume and from businesses to invest. So far, the ongoing reduction in demand is proceeding in an orderly fashion, without abrupt shocks that might destabilise the value of credit assets and credit providers.

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Higher rates also curtail the supply of credit, by increasing the constraints on bank balance sheets, which in turn leads to a slowdown in the credit multiplier. At present, signs of tightening credit supply are less obvious than those of weakening demand. Growth in lending so far remains robust, with credit card loans especially showing no strong signs of plateauing — something that in itself perhaps highlights a source of risk. Indeed, the loosening of underwriting standards that took place in 2020 has helped to push up the value of credit card loans, by providing credit cards to people with low credit scores. However, the same people may struggle to repay at higher rates if their earnings do not keep pace with inflation or their jobs disappear altogether.

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The above bank data suggest that the growth in credit supply has perhaps topped but has not started receding. The NFIB survey points to an increasing share of businesses finding it harder to access credit; specifically, 6% more responders claimed that they were finding it harder to get a loan than those claiming that they found it easier. Although that figure is near its median, the speed at which we reached it — within the three months from July to October — could be the first sign of a warning light flashing for the grassroots parts of the economy.

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Additionally, the spread on banks’ contingent debt (which converts into common equity if banks’ capital adequacy ratios drop too low) has started to rise in 2022, a proxy for a more constrained operating environment for banks. In sum, supply of credit is starting to become limited for small business, but it is expanding for credit cardholders — a dynamic that can potentially be a source of vulnerability, if it goes on unchecked by monetary and fiscal policymakers.

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Overall, the curtailment of credit through the hiking of rates does not seem to have caused large credit asset devaluations or threatened sudden deleveraging so far. But reactions to credit policies may change rapidly in the current volatile environment, as the UK government can testify. Fathom will provide a more complete discussion of the implications of tightening monetary policies for credit demand and supply and, in turn, for the economy and the markets, in its upcoming Global Outlook, Winter 2022 – key charts from this will be available to all Refinitiv users through Chartbook from mid-December.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

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