Credit-Market Sentiment and the Business Cycle

57 Pages Posted: 11 Jan 2017

See all articles by David Lopez-Salido

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: 2015-04-25

Abstract

Using U.S. data from 1929 to 2015, we show that elevated credit-market sentiment in year t-2 is associated with a decline in economic activity in years t and t+1. Underlying this result is the existence of predictable mean reversion in credit-market conditions. When credit risk is aggressively priced, spreads subsequently widen. 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, 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 investor sentiment in credit markets 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 (2015-04-25). FEDS Working Paper No. 2015-28. Available at SSRN: https://ssrn.com/abstract=2896638 or http://dx.doi.org/10.17016/FEDS.2015.028r1

David Lopez-Salido (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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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
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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