Liberty Street — The Macro Effects of the Recent Swing in Financial Conditions

Credit conditions tightened considerably in the second half of 2015 and U.S. growth slowed. We estimate the extent to which tighter credit conditions last year were responsible for the slowdown using the FRBNY DSGE model. We find that growth would have slowed substantially more had the Federal Reserve not delayed liftoff in the federal funds rate.…

Increases in credit spreads tend to be associated with subsequent slowdowns in economic activity, with the Great Recession being a salient example. In part, such increases reflect investors’ concerns about future economic conditions, changes in firms’ leverage, heightened worries about borrowers’ default, and so on. However, as Simon Gilchrist and Egon Zakrajšek and others have shown in their research, such increases in credit spreads often cause an economic slowdown. A natural question is then: Did the rise in credit spreads reflect deteriorating economic conditions or did the causality run the other way around in this episode?

To answer this question, we need an economic model that can disentangle the various channels at work. We use the FRBNY DSGE model, which is a very stylized representation of reality that formalizes key interactions among critical economic actors such as households, firms, the financial sector, and the government. The model is then estimated using Bayesian methods, combining prior information about parameters with important macroeconomic data.…

The model attributes most of the increase in spreads from 2015:Q3 to 2016:Q1 to unexpected disturbances—which we will refer to as “financial shocks.” These shocks reflect developments that are not fully captured by the model. In late 2015, these developments include a downward revision in the foreign outlook and the deteriorating creditworthiness of the U.S. energy sector owing to the drop in energy prices.…

Why did GDP growth not fall by more, then, with such a powerful combination of adverse shocks? According to the model, the answer lies in large part with monetary policy.…

The model suggests that by maintaining the federal funds rate lower, the FOMC managed to substantially offset the effect of tightening financial conditions on the economy. As financial markets revised downward their expectations of interest rate renormalization, the rate at which firms and households could borrow remained low in spite of the increase in spreads.…

The model doesn't look at loosening of fiscal stance?

It is important to remember, however, that our analysis relies on a model that is necessarily a stylized representation of reality. As such, model implications need to be taken with caution.

FRBNY — Liberty Street Economics
The Macro Effects of the Recent Swing in Financial Conditions

Marco Del Negro, Marc Giannoni, and Micah Smith