What do banks know about the economy that economists don't?

Bloomberg News

How's the economy doing? It depends who you ask. 

Any reader of these pages will be aware that since inflation started spiking back in 2021, the Fed has been on a mission to tame inflation without also spurring a recession and/or having inflation spike instead, achieving a so-called "soft landing." As a general matter, soft landings are rare — interest rate hikes tend to result in less lending and economic contraction, which reduces inflation but also can lead firms to lower their overhead, often in the form of payroll.  

So the odds were always long that the Fed would slay the inflation dragon without also slaying the economy — Bloomberg went so far in September 2022 as to declare a recession to be absolutely certain within a year. 

But here we are in January 2024 and, at least as far as we know, we're not in a recession. And that's not all: Inflation is falling and employment remains relatively healthy. Federal Reserve Gov. Chris Waller said in a speech at the Brookings Institution today that, as of November, "the latest economic data left me encouraged" and that "as of today, the data has come in even better. 

"Real gross domestic product is expected to have grown between 1-2% in the fourth quarter, unemployment is still below 4% and core personal consumption expenditure inflation has been running close to 2% for the last 6 months," Waller said. "For a macroeconomist, this is almost as good as it gets."

But when it comes to banks, the assessment of the economy is considerably less rosy. The Conference of State Bank Supervisors — a group that represents state banking regulators — reported that its most recent Community Bank Sentiment Index from Q4 2023 was 92, which is up from the prior quarter but still marks the eighth quarter of negative economic vibes among community banks. (A score of 100 is neutral; scores below 100 represent a negative sentiment, above 100 a positive sentiment.) More to the point, 81% of community bankers surveyed said that the economy was at the beginning of — or already in — a recession (though that's down from 87% the prior quarter).

Politics and policy

Banks ask Biden to rethink more stringent regulation

December 21, 2023 3:42 PM

The CSBS annual survey of banks painted a similarly dour view of the economy, with a majority of respondents (58.1%) reporting that inflation was manageable but likely to persist and another 14.6% saying it was difficult to manage and likely to persist. Similar proportions of respondents said the Fed would hit its 2% inflation target in 2024 and said it would come in 2025; another 12% thought it wouldn't come until 2026 or later.

Then there's the Federal Reserve's regular survey of economic activity in its regional Fed districts, known as the Beige Book. In the most recent iteration (another one is out tomorrow), the Fed reported a mixed bag; travel and tourism seem healthy, demand for business loans is down (particularly for real estate loans), manufacturers' outlooks weakened and consumer credit seems mostly fine. 

So what gives? How can the economy be "as good as it gets" on the one hand and so iffy for banks on the other? 

Part of it is that banks occupy a special place in the economy that is not necessarily representative of the economy as a whole, and that is particularly true at the individual bank level. Community banks, for example, make roughly 70% of agricultural loans in the United States — dips and dives in the ag sector, therefore, will weigh heavier on their prospects than on macroeconomists' 50,000-foot view. The capital-E Economy is also an agglomeration of many smaller, local economies — local economies that may have localized recessions that are dampening loan demand and making banks that serve those areas have a bad time.

But the other part of it is that curbing demand — at least to a measured extent — is the outcome that the Fed is looking to achieve, and lending to people who demand goods and services is the business that banks are in. When people are doing less of that — or, more accurately, doing less of that for some things versus others — that means there is a smaller universe of potential loans out there for banks to make. And higher interest rates from the Fed also mean higher cost of funds to the bank, lower values for existing securities and lower net interest margins — concerns that affect banks acutely.

In other words, banks are uniquely situated to see the economy as a half-empty glass rather than a half-full one. It is possible — indeed, it seems to be the case — that the economy is strong as a whole but has patches of recession in the mix. The danger is whether, out of an abundance of caution, banks will keep holding back on lending even after the coast is clear.