February 12, 2016 / 9:02 PM / 2 years ago

Tougher lending standards pose risk to outlook for Fed

Snow rests on the eagle statue atop the U.S. Federal Reserve in Washington January 26, 2016.Jonathan Ernst

WASHINGTON (Reuters) - A recent tightening of credit for U.S. companies is threatening to undermine economic growth, making it less likely the Federal Reserve will raise interest rates anytime soon.

Fed Chair Janet Yellen said this week it was still too soon for the central bank to change its view that rate hikes are needed, a position supported by a still-robust pace of hiring that is helping consumers borrow more readily.

But a tightening of lending standards for U.S. businesses and rising corporate credit spreads suggest global financial market turmoil could lead the Fed next month to signal fewer rate hikes this year than the four increases policymakers signaled in December.

"Financial conditions are tightening the Fed's belt," Deutsche Bank, which expects one rate increase this year, said in a note to clients on Friday.

A net 4.2 percent of banks tightened standards on U.S. commercial and industrial loans to small firms in the fourth quarter, the highest level since late 2009, when the United States was just emerging from a deep recession, according to the Fed's Senior Loan Officer Opinion Survey.

While U.S. banks are still making it easier to get credit cards, tighter credit standards for small companies suggest global financial stress is spreading beyond export-oriented U.S. companies.

The question facing the Fed is: How much further will the tightening spread?

Yellen told lawmakers on Wednesday the Fed was assessing the potential impact from tighter lending standards and widening corporate credit spreads but said it was "premature" to decide whether the global shocks could change the interest rate outlook.

"It depends in part on whether they persist," she told lawmakers at a second hearing on Thursday.

The Fed was in a similar situation in September, when plunging global equity markets - including a 9 percent drop in the S&P 500 in the prior two months - and worries about China's economy helped convince policymakers to hold off on a rate hike.

Financial markets subsequently recovered and the Fed went on to raise rates in December and signal expectations of four more increases in 2016.

Since then, global markets have soured once again, with European banking shares hit by concerns over Deutsche Bank's financial health and the potential for a recession in China, the world's second-largest economy.

Prices for Federal Funds futures <0#FF> suggest investors do not expect any rate hikes this year. Tighter lending standards were a factor leading JPMorgan to increase its view of the chance of a recession in the next 12 months to 32 percent from 21 percent in mid-January.

Also worrisome for Yellen, investment-grade U.S. corporations are paying higher interest rates on bonds relative to U.S. government debt .MERC0A0 even though companies are readily accessing bond markets and overall banking credit grew more than 7 percent in the year through Jan. 27, according to Fed data.

"A plausible downside risk to the economy is that tougher financial conditions cause firms to slow capital spending and hiring," said Goldman Sachs economist Zach Pandl. "The corporate sector looks comparatively more vulnerable."

Reporting by Jason Lange in Washington; Editing by Dan Grebler

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