Written by Aaron Hartfield

This essay summarizes the findings presented in a Chicago Fed Letter titled “The Interplay Between Financial Conditions and Monetary Policy Shocks.” [1] Do not be scared when you download the PDF. It is 51 pages, but the actual content is only 15, with other pages being graphs, references, etc. Before the findings of the Letter are presented, let’s have an introduction to some of the important topics.

What exactly is the Fed funds rate? The Federal Reserve (Fed) requires banks to have enough cash to cover possible withdrawals – a reserve requirement. Banks that hold cash above the reserve requirement can loan money to banks that do not meet the requirement. The length of the loan is overnight; the interest rate is the Fed funds rate. Not surprisingly, this rate affects the interest rates that banks charge customers and yields on bonds. Adjusting the Fed funds rate is one of the monetary policy tools of the Fed.

In theory and practice the monetary policy conducted by the Fed works to counter the effects of financial conditions. When financial conditions are easy, the Fed tightens monetary conditions and visa-versa. The authors of the Letter determine monetary conditions by looking at the Fed funds rate and financial conditions by looking at a few different measures, with the main measure being the excess bond premium.

What is the excess bond premium (EBP)? It is a measure of corporate bond spreads not attributable to expected default risk, first introduced in a 2012 paper by Gilchrist and Zakrajšek.[2] Corporate bond spreads are the difference in the yields between investment grade corporate bonds and similar duration Treasury securities. Gilchrist and Zakrajšek split corporate bond spreads into 2 components – default risk and EBP. They argue that the EBP is predictive of future output.

The green line (or the lowest line) in the chart below is the corporate bond spread.

How does the EBP predict future output? Corporations sell bonds to fund investments. The yield on corporate bonds can be thought of as the interest that the corporation must pay on its loans, similar to the interest rate that an individual pays on a car loan or home mortgage. Since the default risk of investment grade bonds should be relatively constant through time, an increase in corporate bond yields can be attributed to an increase in the EBP. The EBP can be viewed as an indicator of investor sentiment or risk appetite in the corporate bond market.

A decrease in investor sentiment leads to an increase in the EBP, resulting in higher interest payments for corporations and tighter financial conditions. (Look at the graph of the corporate bond spread again. Notice how the spread increased significantly during the Great Recession in 2008 and 2009, indicating tight financial conditions.) Tighter financial conditions result in corporations investing less, decreasing future output. When this happens, the Fed looks to counter by loosening monetary conditions. Let’s look at how this works in theory.

Investor sentiment in the corporate bond market decreases, resulting in an increased EBP and tighter financial conditions. The Fed notices the tighter financial conditions and decreases the Fed funds rate. This leads to a decrease in interest rates on bank loans. Individuals take out loans for cars and homes and small businesses take out loans for investment. Aggregate demand increases, which leads to an increase in investor sentiment in the corporate bond market, lowering the EBP and loosening financial conditions.

Aggregate demand is also stimulated through the exchange rate. When the Fed lowers the Fed funds rate, bond yields fall. This decreases demand from foreign investors in dollar denominated bonds. Since demand for dollars has decreased, the exchange rate falls. U.S. exports are cheaper and imports are more expensive, resulting in an increase in aggregate demand.

This is the paradigm that the Fed uses when making monetary policy decisions. The Chicago Fed Letter examines the effectiveness of monetary policy and covers 3 topics. 1) Comparing the effects of monetary shocks versus financial shocks. 2) How successful is monetary policy? 3) What happens when there is no monetary policy response to financial shocks? A monetary shock is a movement in the Fed funds rate and a financial shock is a movement in the excess bond premium.

The findings for the first topic are what economists have claimed for a while – the effects of monetary shocks take longer to work through the economy and are variable; the effects of financial shocks peak quickly and die out fast. To reach this conclusion the authors measure effects on gross domestic product (GDP) and business fixed investment (BFI). They find that financial shocks have a larger effect on BFI than monetary shocks, with monetary shocks having a larger effect on GDP. They determine the size of the effect by measuring how far the measure (BFI or GDP) is from trend. Both easy financial and monetary conditions have positives effects on GDP and BFI.

The second topic is attempting to determine how effective the Fed is at countering financial conditions. The authors find that the effects from financial shocks are 50% larger and last 2 years longer with no monetary policy. In other words, monetary policy dampens the effects of a financial shock. Of course, some people may be skeptical toward this finding, as the authors have a vested interest in people believing that monetary policy is effective; however, most economists believe that the authors’ findings are true. The debate is usually about how much the Fed should do to counter financial shocks and if countering financial shocks actually causes more economic volatility in the long run.

The third topic of the paper is looking at current monetary conditions. The Fed’s current target for the Fed funds rate is 0.25-0.5%, with the recent effective Fed funds rate being around 0.41%. At this level, known as the zero-lower bound (ZLB), the Fed will have little room to counter the effects of an increase in the EBP (no monetary policy). The Letter explores how the model reacts to the ZLB.

The graph below displays the effective Fed funds rate over the last 20 years and demonstrates what economists mean when they talk about the ZLB.

The model reaction to the ZLB was measured retroactively. The authors took historical data and when monetary policy reacted to a financial shock, they inserted into the model a counter monetary policy, essentially negating any effect from monetary policy. Using different measures of financial conditions, the finding was “in all but one of these cases, we find that the ZLB contributes to generate instability in the response to the financial shocks.”

This Letter, especially the third topic, may be viewed as the Chicago Fed telling the other members of the Fed that it is time to increase the Fed funds rate. Indeed, if the EBP begins to dramatically increase, the Fed will not be able to counter by lowering the Fed funds rate. And because the effects of monetary policy are not felt immediately (the first topic), an increase in the Fed funds rate at the December meeting will not slow the recovering economy anytime soon.

Will the Fed raise the Fed funds rate at the December meeting? At this point, they probably should, as most of the market is expecting an increase. (The probability for a December rate increase is at about 90%.) If the Fed decides to not raise rates, it is likely that there will be volatility in the market. And if that volatility leads to an increase in the EBP, the Fed will not be able to use the Fed funds rate to counter the effects.

[1] Bassetto, Marco, Luca Benzoni, and Trevor Serrao. 2016. “The Interplay Between Financial Conditions and Monetary Policy Shocks.” Federal Reserve Bank of Chicago October WP 2016-11.

[2] Gilchrist, Simon, and Egon Zakrajšek. 2012. “Credit Spreads and Business Cycle Fluctuations.” American Economic Review 102 (4): 1692-1720.