Loose Credit What It Means How It Works

Loose Credit: What It Means, How It Works

What Is Loose Credit?

Loose credit is the relaxation of lending practices by banks and other financial institutions to make it easier for more people to take on loans.

A country’s central bank effectively makes credit "loose" or "tight" by forcing lending rates lower or higher. Lower government lending rates pump more money into the banking system, making the banks more eager to loan money. Higher rates mean less money to lend out, and fewer customers willing and able to borrow.

A loose credit economic environment may also be called accommodative monetary policy or loose monetary policy.

Key Takeaways

– Loose credit, as a monetary policy, stimulates the economy by making it cheaper for people and businesses to borrow money.

– To financial institutions, loose credit means more money to lend at lower interest rates.

– In the U.S., the Federal Reserve responded to the economic challenges caused by the Covid pandemic by loosening credit. Beginning in March 2022, it reversed its policy and began tightening credit to slow inflation.

11 Interest Rate Hikes

Understanding Loose Credit

Central banks differ on the mechanisms they have to create loose or tight credit environments. Most have a central borrowing rate that affects the largest banks and borrowers first; they then pass the rate changes along to their customers.

These changes quickly work their way down to the individual consumer via credit card interest rates, mortgage loan rates, and rates on investments such as money market funds and certificates of deposit (CDs).

Central banks can also loosen credit through large-scale asset purchases, known as quantitative easing. It involves purchasing government-backed or other assets to pump money into bank reserves, ready to be loaned out. It does not directly lower interest rates or loosen credit conditions, but floods the banking system with liquidity in the expectation that the banks will lend it out.

In modern times, central banks loosen credit to prevent or mitigate a recession and tighten credit when the effects of loose credit start to show up in the form of higher consumer prices.

Loose Credit in Recent Years

The U.S. markets were considered a loose credit environment between 2001 and 2006—the Federal Reserve lowered the Fed funds rate and interest rates reached their lowest levels in more than 30 years.

The Fed then tightened monetary policy for a couple of years. However, at the start of the 2008-2009 economic crisis, the Fed reverted to its loose credit policy, lowering the benchmark rate to 0.25%. It remained at this rock-bottom level until December 2015 when the Fed raised the rate to 0.5%.

The periods of loose credit were intended to encourage lenders to lend and borrowers to take on more debt. This should also lead to increased asset prices and spending on goods and services as the newly created money enters the economy.

From 2016 to 2018, the Fed began gradually tightening monetary policy again in small increments.

The Fed then began loosening policy again, dropping rates through the second half of 2019 in the hopes of avoiding a recession. With the onset of the COVID-related shutdown of much of the world economy in 2020, the Fed kicked off a new round of extremely loose money and credit policy to buffer some of the ongoing economic damage.

What Are Tight Monetary Policy and Loose Monetary Policy?

Tight monetary policy means forcing interest rates higher to slow down an overheating economy prone to inflation. When interest rates are higher, consumers and businesses borrow and spend less. Demand for goods and services declines. Prices stabilize or drop.

Loose monetary policy is the opposite. Interest rates are forced downwards to jump-start the economy and create jobs. Consumers and businesses buy and borrow more. Demand for goods and services increases, and production increases to meet the demand.

What Is Expansionary Monetary Policy?

Expansionary monetary policy, also known as loose money policy, requires lower interest rates to encourage borrowing and spending by consumers and businesses. Production increases, and jobs are created to meet the demand.

In addition to reducing interest rates, central banks have other tools to spur economic growth:

– Reducing reserve requirements on banks makes more money available for lending to businesses seeking to expand and consumers ready to spend.

– Quantitative easing involves government purchases of large amounts of government-backed securities to add cash to the system for reinvestment.

What Does Loose Credit Mean for Consumers?

Loose credit means lower interest rates and usually easier lending standards. When banks have a great deal of cash to lend, they are more likely to relax their standards, allowing consumers and businesses with less-than-perfect credit ratings to borrow. Those lower rates also increase the total amount of debt that a consumer can afford to take on.

The Bottom Line

Monetary policy may seem to create a cycle of loose credit causing inflation and tight credit causing a recession. In fact, policymakers aim for a reasonable middle ground of low unemployment and low inflation.