Credit-Market Sentiment and the Business Cycle

46 Pages Posted: 20 Jan 2016 Last revised: 14 Apr 2023

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

Bank for International Settlements (BIS)

Multiple version iconThere are 3 versions of this paper

Date Written: January 2016

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.

Suggested Citation

Lopez-Salido, David and Stein, Jeremy C. and Zakrajsek, Egon, Credit-Market Sentiment and the Business Cycle (January 2016). NBER Working Paper No. w21879, Available at SSRN: https://ssrn.com/abstract=2717290

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 )

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Egon Zakrajsek

Bank for International Settlements (BIS) ( email )

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