Report

Monetary cycles, financial cycles, and the business cycle

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);

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2010

Number: 421