Credit Spreads and Business Cycle Fluctuations

37 Pages Posted: 9 May 2011 Last revised: 14 May 2011

See all articles by Simon Gilchrist

Simon Gilchrist

Boston University - Department of Economics; National Bureau of Economic Research (NBER)

Egon Zakrajsek

Federal Reserve Board - Division of Monetary Affairs

Date Written: May 2011

Abstract

This paper examines the evidence on the relationship between credit spreads and economic activity. Using an extensive data set of prices of outstanding corporate bonds trading in the secondary market, we construct a credit spread index that is--compared with the standard default-risk indicators--a considerably more powerful predictor of economic activity. Using an empirical framework, we decompose our index into a predictable component that captures the available firm-specific information on expected defaults and a residual component--the excess bond premium. Our results indicate that the predictive content of credit spreads is due primarily to movements in the excess bond premium. Innovations in the excess bond premium that are orthogonal to the current state of the economy are shown to lead to significant declines in economic activity and equity prices. We also show that during the 2007-09 financial crisis, a deterioration in the creditworthiness of broker-dealers--key financial intermediaries in the corporate cash market--led to an increase in the excess bond premium. These find- ings support the notion that a rise in the excess bond premium represents a reduction in the effective risk-bearing capacity of the financial sector and, as a result, a contraction in the supply of credit with significant adverse consequences for the macroeconomy.

Suggested Citation

Gilchrist, Simon and Zakrajsek, Egon, Credit Spreads and Business Cycle Fluctuations (May 2011). NBER Working Paper No. w17021. Available at SSRN: https://ssrn.com/abstract=1833158

Simon Gilchrist (Contact Author)

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Egon Zakrajsek

Federal Reserve Board - Division of Monetary Affairs ( email )

20th and C Streets, NW
Washington, DC 20551
United States
202-728-5864 (Phone)
202-452-3819 (Fax)

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