A new research paper from the New York Fed connects some of the dots for thinking that monetary policy, balance sheets in banking, leverage, credit cycles and macro risk premiums are related (“Macro Risk Premium and Intermediary Balance Sheet Quantities“). That’s hardly shocking, or at least it shouldn’t be. But revisiting the economic plumbing is refreshing, not to mention necessary, as far too many pundits go off the deep end in assigning blame and evaluating cause and effect.
“Monetary policy affects risk appetite by changing the ability of intermediaries to leverage their capital,” the paper observes. Using yield spreads as a proxy for the macroeconomic risk premium, the authors show that the financial sector’s risk appetite fluctuates inversely with the macro premium, as per the chart below (reproduced from the paper).
One implication is that credit supplies flowing from the banking sector drives the business cycle. But what’s the source of fluctuations in the credit supply? The Federal Reserve, for obvious reasons, plays a role, and more than a trivial one. How could it be otherwise when your primary asset is the printing press that determines the nation’s money supply?
“A lower Fed funds target precedes higher risk appetite,” the paper demonstrates. Meanwhile, “A higher Fed Funds target increases the costs of leverage of financial intermediaries, and thus lowers their risk appetite. A lower risk appetite reduces the supply of credit and is hence associated with higher spreads and lower real activity.”
Such ideas constitute radical thinking in some circles, or perhaps this linkage is simply ignored to make a political point. Regardless, “Monetary policy actions that affect the risk-taking capacity of the banks will lead to shifts in the supply of credit,” the paper advises. It follows, then, that during “the run-up to the global financial crisis of 2007 to 2009, the financial system was said to be ‘awash with liquidity,’ in the sense that credit was easy to obtain.”
Why is this a critical point? The paper lays out the basic framework: “When asset prices rise, financial intermediaries’ balance sheets generally become stronger, and – without adjusting asset holdings – their leverage becomes eroded. The financial intermediaries then hold surplus capital, and they will attempt to find ways in which they can employ their surplus capital. Monetary policy can affect the balance sheet behavior of financial intermediaries, which in turn influence the supply of credit, risk premia, and ultimately the level of real activity.”
The central bank, it seems, is front and center in the business cycle, for good or ill. A small library of research demonstrates no less. Granted, there’s more to the business cycle than monetary policy. But at the very least, minimizing the role of credit policy risks ignoring the elephant in the room. That doesn’t mean that the basics are forever understood and recognized. In some corners of punditry and economic analysis, the basics seem to be overlooked, forgotten or simply dismissed.