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Credit-Market Sentiment and the Business Cycle

David Lopez-Salido (), Jeremy Stein () and Egon Zakrajsek ()

No 2015-28, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (US)

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 (search for similar items in EconPapers)
JEL-codes: E32 E44 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-mac
Date: 2015-04-25, Revised 2016-12-30
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Related works:
Journal Article: Credit-Market Sentiment and the Business Cycle (2017) Downloads
Working Paper: Credit-Market Sentiment and the Business Cycle (2016) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2015-28

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DOI: 10.17016/FEDS.2015.028r1

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