Monetary cycles, financial cycles, and the business cycle

Tobias Adrian, Arturo Estrella and Hyun Song Shin

No 421, Staff Reports from Federal Reserve Bank of New York

Abstract: One of the most robust stylized facts in macroeconomics is the forecasting power of the term spread for future real activity. The economic rationale for this forecasting power usually appeals to expectations of future interest rates, which affect the slope of the term structure. In this paper, we propose a possible causal mechanism for the forecasting power of the term spread, deriving from the balance sheet management of financial intermediaries. When monetary tightening is associated with a flattening of the term spread, it reduces net interest margin, which in turn makes lending less profitable, leading to a contraction in the supply of credit. We provide empirical support for this hypothesis, thereby linking monetary cycles, financial cycles, and the business cycle.

Keywords: Business cycles; Interest rates; Forecasting; Monetary policy; Intermediation (Finance) (search for similar items in EconPapers)
Date: 2010
New Economics Papers: this item is included in nep-ban, nep-bec, nep-cba, nep-for, nep-mac and nep-mon
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