Working Paper: NBER ID: w21879
Authors: David López-Salido; Jeremy C. Stein; Egon Zakrajsek
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 and t + 1. 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: credit market sentiment; business cycle; economic activity; credit spreads; financial frictions
JEL Codes: E32; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| elevated credit market sentiment in year t-2 (G12) | decline in economic activity in years t and t-1 (F44) |
| narrow credit spreads and elevated high-yield bond issuance (G19) | significant slowing in real GDP growth (F62) |
| narrow credit spreads and elevated high-yield bond issuance (G19) | significant slowing in business investment (G31) |
| narrow credit spreads and elevated high-yield bond issuance (G19) | significant increase in unemployment rate (F66) |
| time-variation in expected returns to credit market investors (G12) | drive economic fluctuations (E32) |
| credit market sentiment (E44) | changes in economic activity (E39) |
| stock market sentiment (G10) | changes in economic activity (E39) |