Friday, January 8, 2010

On Monetary, Financial and Business Cycles (fg)

Typically, theories of monetary transmission highlight the role of real interest rates for shaping credit demand through the cost of capital. In this setting, the term spread is a reliable indicator for forecasting business cycle downturns.

New research of Adrian and Shin (2010) re-examine the transmission of monetary policy to the real economy by connecting the term spread and the balance sheet management of financial intermediaries motivated by the balance sheet and risk-taking channel of monetary policy transmission:
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.