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Lending activity is generally considered a lagging indicator of the business cycle, and rightly so. A look at a long-term chart of business loans, for instance, shows that this series has been known to rise well after the start of a new recession. But is the value of this indicator more timely in the current climate, in which the pain of the credit crunch is seared into the collective memory?

The financial sector is still skittish after suffering heavily in the Great Recession. Indeed, no corner of the economy took a heavier blow than finance. The slump of 2007-2009 was, after all, partly triggered by an unusually deep financial crisis. It's only natural that banks, even after nearly three years of modest economic growth, are still cautious. If so, what does that say about the continuing rise in business loans generally?

The latest numbers on commercial and industrial loans, as compiled by the Federal Reserve, show that lending is still rising. The actual dollar amounts can be misleading, however, if we're trying to gauge the broad moves in the economy. A slightly better approach is to look at rolling 12-month percentage changes. History shows that when a new recession strikes, the annual pace of business lending, if it isn't already falling, peaks relatively early once the economy begins to shrink. The lone exception to this rule for the past nine recessions is the 1981-1982 slump.

Economist John Silvia of Wells Fargo tells us in Dynamic Economic Decision Making:

Popular wisdom holds that the economy needs banks to lend before the economy gets going. In reality, businesses are cautious about borrowing at the start of the recovery and will invest their own cash first and then borrow at the bank. Meanwhile, the bank is also cautious since it probably has some bad loans it wants to work off from the last recession. As a result, bank lending is a lagging, not leading, indicator of the recovery.

Business lending these days continue to climb at a robust rate over year-earlier levels (see chart below). Through February, commercial and industrial loans rose 12.2% vs. the same month from 2011, according to Fed data. That's up from January's 11.0% pace and by far the highest rate of increase since the Great Recession ended in mid-2009.

The weekly reports through the end of March show more of the same. Commercial and industrial lending totaled $1.39 trillion (seasonally adjusted annual rate) as of March 28, 2012 -- up 11.6% vs. the last week of March 2011.

Bank loans are just one statistic, of course, and traditionally these numbers are considered of limited use as an early signal of economic trouble. When the economy faced new headwinds last spring, and during the spring of 2010 too, business lending didn't flinch from its revival. Maybe that was a sign of confidence that the economic recovery would survive, as it has so far.

In the meantime, it's worth remembering that the economic turmoil in recent years has been accompanied by the deepest financial-sector crisis since the Great Depression. It's reasonable to wonder if banks are more sensitive to recession risk these days. If so, is commercial lending activity more likely to dry up earlier than usual if loan officers think the economy's set to falter? In that case, can we take comfort from the fact that banks continue to extend credit to the business community?

The answers are unavoidably speculative. What we do know is that bank lending continues to expand. That alone is no guarantee that the economy will dodge a bullet. On the other hand, any decline in lending activity would be seen as ominous in the current climate. For the moment, however, the lending skies still look sunny.

Source: Is Commercial Loan Growth A Positive Sign For The Economy?