Larry DeBoer
Professor of
Agricultural Economics
Purdue University

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If Lenders Lend Again

The unemployment rate is climbing, topping 8 percent for the nation, 9 percent for Indiana. It will keep rising. Gross Domestic Product fell more than 6 percent in the fourth quarter. It will fall again this quarter. When will all this bad news end?

Ben Bernanke, our Federal Reserve chairman, says that the economy can't really recover until the banking system recovers. Banks and other lenders have to be willing to make loans.

We can keep track of the economy's production with gross domestic product and of job prospects with the unemployment rate. How can we keep track of lending? One way is with interest rate spreads.

One of the better indicators of financial market condition is the difference between the three month commercial interest rate and the three month Treasury bill interest rate. I first learned about this one from a 1990 article by a Princeton University professor named Ben Bernanke (in the New England Economic Review, November/December 1990).

Banks and other lenders have to choose where to put their money. They can lend to the government. They can lend to businesses. Lending to businesses is riskier. If the business doesn't do well maybe the loan won't be repaid. That's not a problem when lending to the federal government. The U.S. Treasury never misses an interest payment.

Usually the spread between the commercial and Treasury interest rates is about two-tenths of a point. The business rate is higher to encourage lenders to make those riskier loans. When the economy is expanding and the outlook for business is good, those business loans aren't that much more risky. So the interest rate spread is small.

Sometimes lenders get nervous about the prospects of businesses. They decide to play it safe, and lend more to the government. When that happens, the government doesn't need to pay as much interest to borrow money. But with fewer funds coming their way, businesses must pay more. The interest rate spread gets big. That makes it a good indicator of lender nerves.

The spread began to get big in early 2007, and, when financial markets collapsed in October 2008, the spread widened to two-and-a-half points for the month, the highest since December 1980. Lenders were really nervous about getting repaid.

But by February the commercial-Treasury spread had dropped to a monthly average of 0.37 percent, the lowest since April 2007. And, so far in March, the spread has been 0.43 percent. Not quite back to normal, but an indication that lenders are less nervous about business loans than they've been in almost two years.

Bernanke also found that the commercial-Treasury spread is a good leading indicator of recessions and expansions. A leading indicator is one that turns sour before recessions start and perks up before recessions end.

In the last recession the spread hit its low point in March 2000, one year before the start of the 2001 recession. It started rising after that. It peaked several times over the next year and a half, the last time in April 2001. That was seven months before the 2001 recession ended in November.

This time, the spread reached its low point in February 2007, ten months before the December start of the current recession. And, apparently—we hope—it peaked in October 2008.

If that really was the high point for the spread, then we should expect the recession to end within a year or so of last October.

So as not to cause unruly celebration at this news, here are a couple of cautions. The commercial-Treasury spread almost always has a lot of ups and downs around the beginnings and endings of recessions. The peak that was the "last" before the spread fell sometimes is only clear in hindsight.

And, by economists' way of thinking, the end of a recession is the economy's low point. For the first few months of recovery, the economy is still pretty close to that low point. The end of a recession doesn't mean everything is suddenly OK.

Still, the interest rate spread says that lenders might be starting to lend again, and the interest rate spread is a leading indicator. The recession isn't over, but the end may be in sight.



Writer: Larry DeBoer
Editor: Cindie Gosnell