Credit-Market Sentiment and the Business Cycle

FEDS Working Paper No. 2015-028r1

http://dx.doi.org/10.17016/FEDS.2015.028r1

57 Pages Posted: 24 May 2015  

David Lopez-Salido

Board of Governors of the Federal Reserve System

Jeremy C. Stein

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

Egon Zakrajsek

Federal Reserve Board - Division of Monetary Affairs

Multiple version iconThere are 3 versions of this paper

Date Written: April 20, 2015

Abstract

Using U.S. data from 1929 to 2013, we show that elevated credit-market sentiment in year t-2 is associated with a decline in economic activity in years t through t 2. Underlying this result is the existence of predictable mean reversion in credit-market conditions. That is, when our sentiment proxies indicate that credit risk is aggressively priced, this tends to be followed by a subsequent widening of credit spreads, and the timing of this widening is, in turn, closely tied to the onset of a contraction in economic activity. Exploring the mechanism, we find that buoyant credit-market sentiment in year t-2 also forecasts a change in the composition of external finance: net debt issuance falls in year t, while net equity issuance increases, patterns consistent with the reversal in credit-market conditions leading to an inward shift in credit supply. Unlike much of the current literature on the role of financial frictions in macroeconomics, this paper suggests that time-variation in expected returns to credit market investors can be an important driver of economic fluctuations.

Keywords: business cycles, credit-market sentiment, financial stability

JEL Classification: E32, E44, G12

Suggested Citation

Lopez-Salido, David and Stein, Jeremy C. and Zakrajsek, Egon, Credit-Market Sentiment and the Business Cycle (April 20, 2015). http://dx.doi.org/10.17016/FEDS.2015.028r1. Available at SSRN: https://ssrn.com/abstract=2604149 or http://dx.doi.org/10.2139/ssrn.2604149

David Lopez-Salido

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
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United States

Jeremy C. Stein

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States
617-496-6455 (Phone)
617-496-7352 (Fax)

HOME PAGE: http://post.economics.harvard.edu/faculty/stein/stein.html

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Egon Zakrajsek (Contact Author)

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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