We re-examine the evidence on the relationship between credit spreads and economic activity, by constructing a credit spread index based on an extensive data set of prices of outstanding corporate bonds trading in the secondary market. Compared with the standard default-risk indicators, our credit spread index is a robust predictor of economic activity at both the short- and longer-term horizons. Using an empirical framework, we decompose the index into a predictable component that captures the available firm-specific information on expected defaults and a residual component—the excess bond premium—which we argue likely reflects variation in the price of default risk rather than variation in the risk of default. Our results indicate that the predictive content of credit spreads for economic activity 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 a deterioration in the creditworthiness of broker-dealers—key financial intermediaries in the corporate cash market—causes an increase in the excess bond premium. These findings support the notion that a rise in the excess bond premium represents a reduction in the e!ective 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.

/pdf/credit-spreads-and-business-cycle-fluctuations-2hg0cfvcs2.pdf

Credit Spreads and Business Cycle Fluctuations

The financial crisis has refocused attention on money and credit fluctuations, financial crises, and policy responses. We study the behavior of money, credit, and macroeconomic indicators over the long run based on a new historical dataset for 14 countries over the years 1870-2008. Total credit has increased strongly relative to output and money in the second half of the twentieth century. Monetary policy responses to financial crises have also been more aggressive, but the output costs of crises have remained large. Credit growth is a powerful predictor of financial crises, suggesting that policymakers ignore credit at their peril. (JEL E32, E44, E52, G01, N10, N20)

/pdf/credit-booms-gone-bust-monetary-policy-leverage-cycles-and-4qfulz4cp9.pdf

Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008

We investigate the small-sample properties of three alternative generalized method of moments (GMM) estimators of asset-pricing models. The estimators that we consider include ones in which the weighting matrix is iterated to convergence and ones in which the weighting matrix is changed with each choice of the parameters. Particular attention is devoted to assessing the performance of the asymptotic theory for making inferences based directly on the deterioration of GMM criterion functions.

Finite sample properties of some alternative GMM estimators

We provide evidence on the transmission of monetary policy shocks in a setting with both economic and financial variables. We first show that shocks identified using high frequency surprises around policy announcements as external instruments produce responses in output and inflation that are typical in monetary VAR analysis. We also find, however, that the resulting "modest" movements in short rates lead to "large" movements in credit costs, which are due mainly to the reaction of both term premia and credit spreads. Finally, we show that forward guidance is important to the overall strength of policy transmission. (JEL E31, E32, E43, E44, E52, G01)

/pdf/monetary-policy-surprises-credit-costs-and-economic-activity-3tt8ryynpg.pdf

Monetary Policy Surprises, Credit Costs, and Economic Activity †

This paper employs an approximation that makes a nonlinear term structure model extremely tractable for analysis of an economy operating near the zero lower bound for interest rates. We show that such a model oers an excellent description of the data and can be used to summarize the macroeconomic eects of unconventional monetary policy at the zero lower bound. Our estimates imply that the eorts by the Federal Reserve to stimulate the economy since 2009 succeeded in making the unemployment rate in May 2013 0.23% lower than it otherwise would have been.

/pdf/measuring-the-macroeconomic-impact-of-monetary-policy-at-the-1w3qd5quk8.pdf

Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound

This paper reviews a simple three-factor arbitrage-free term structure model estimated by Federal Reserve Board staff and reports results obtained from fitting this model to U.S. Treasury yields since 1990. The model ascribes a large portion of the decline in long-term yields and distant-horizon forward rates since the middle of 2004 to a fall in term premiums. A variant of the model that incorporates inflation data indicates that about two-thirds of the decline in nominal term premiums owes to a fall in real term premiums, but estimated compensation for inflation risk has diminished as well.

/pdf/an-arbitrage-free-three-factor-term-structure-model-and-the-4iajcqn1sx.pdf

An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long- Term Yields and Distant-Horizon Forward Rates

Many recent papers have found that atheoretical forecasting methods using many predictors give better predictions for key macroeconomic variables than various small-model methods The practical relevance of these results is open to question, however, because these papers generally use ex post revised data not available to forecasters and because no comparison is made to best actual practice We provide some evidence on both of these points using a new large dataset of vintage data synchronized with the Fed's Greenbook forecast This dataset consists of a large number of variables, as observed at the time of each Greenbook forecast since 1979 Thus, we can compare real-time large dataset predictions to both simple univariate methods and to the Greenbook forecast For inflation we find that univariate methods are dominated by the best atheoretical large dataset methods and that these, in turn, are dominated by Greenbook For GDP growth, in contrast, we find that once one takes account of Greenbook's advantage in evaluating the current state of the economy, neither large dataset methods nor the Greenbook process offers much advantage over a univariate autoregressive forecast

Comparing Greenbook and Reduced Form Forecasts using a Large Realtime Dataset

For over ten years, the U.S. Treasury has issued index-linked debt. Federal Reserve Board staff have fitted a yield curve to these indexed securities at the daily frequency from the start of 1999 to the present. This paper describes the methodology that is used and makes the estimates public. Comparison with the corresponding nominal yield curve allows measures of inflation compensation (or breakeven inflation rates) to be computed. We discuss the interpretation of inflation compensation and its relationship to inflation expectations and uncertainty, offering some empirical evidence that these measures are affected by an inflation risk premium that varies considerably at high frequency. In addition, we also find evidence that inflation compensation was held down in the early years of the sample by a premium associated with the illiquidity of TIPS at the time. We hope that the TIPS yield curve and inflation compensation data, which are posted here and will be updated periodically, will provide a useful tool to applied economists.

The TIPS yield curve and inflation compensation

Many recent articles have found that atheoretical forecasting methods using many predictors give better predictions for key macroeconomic variables than various small-model methods. The practical relevance of these results is open to question, however, because these articles generally use ex post revised data not available to forecasters and because no comparison is made to best actual practice. We provide some evidence on both of these points using a new large dataset of vintage data synchronized with the Fed’s Greenbook forecast. This dataset consist of a large number of variables as observed at the time of each Greenbook forecast since 1979. We compare realtime, large dataset predictions to both simple univariate methods and to the Greenbook forecast. For inflation we find that univariate methods are dominated by the best atheoretical large dataset methods and that these, in turn, are dominated by Greenbook. For GDP growth, in contrast, we find that once one takes account of Greenbook’s advantage in ev...

/pdf/comparing-greenbook-and-reduced-form-forecasts-using-a-large-3qh5coo3mz.pdf

Comparing Greenbook and Reduced Form Forecasts Using a Large Realtime Dataset

This paper provides a survey of business cycle facts, updated to take account of recent data. Emphasis is given to the Great Recession, which was unlike most other postwar recessions in the United States in being driven by deleveraging and financial market factors. We document how recessions with financial market origins are different from those driven by supply or monetary policy shocks. This helps explain why economic models and predictors that work well at some times do poorly at other times. We discuss challenges for forecasters and empirical researchers in light of the updated business cycle facts.

/pdf/facts-and-challenges-from-the-great-recession-for-1ogqqf6519.pdf

Jonathan Wright

Papers

An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long- Term Yields and Distant-Horizon Forward Rates

Comparing Greenbook and Reduced Form Forecasts using a Large Realtime Dataset

The TIPS yield curve and inflation compensation

Comparing Greenbook and Reduced Form Forecasts Using a Large Realtime Dataset

Facts and Challenges from the Great Recession for Forecasting and Macroeconomic Modeling