Credit Spreads, Monetary Policy and the Price Puzzle

Abstract

Identifying the causal effect of monetary policy on inflation remains a challenge. Researchers frequently find evidence of a 'price puzzle': increases in the policy rate are followed by higher rather than lower inflation. This can be explained by the forward-looking behaviour of the central bank. Inflation does not rise in response to an increase in the policy rate but, instead, the central bank raises its policy rate when it expects inflation to increase in the future. To identify the true causal effects of monetary policy on inflation, it is hence necessary to control for this systematic policy response to expected inflation. For Australia, however, the price puzzle has been found even when controlling for the cash rate's systematic response to the Reserve Bank's own inflation forecasts. I argue that this is due to an additional but omitted systematic response of the cash rate to credit market shocks. Easier credit market conditions lead to an economic expansion and higher inflation. Therefore, the Bank raises the cash rate – its policy rate – when credit spreads decline. However, the Bank's inflation forecasts do not fully capture the inflationary effect of easier credit conditions. As a result, cash rate changes are positively correlated with future inflation even when purging them of the cash rate's response to the Bank's inflation forecasts. Accordingly, I show that accounting for the cash rate's additional response to credit market conditions resolves the price puzzle. As expected, a higher cash rate reduces inflation and output growth, and raises the unemployment rate.

The Real Effects of Debt Covenants: Evidence from Australia

“…Another key departure from Greenwald (2019) is that instead of changes in the cash rate, I employ the newly available series of monetary policy shocks constructed by Beckers (2020). This is because changes in the cash rate are not exogenous, but instead reflect systematic responses to economic conditions, which may have confounding effects on business activity.…”

“…Having demonstrated the substantive direct effects of covenants, I study their role in the transmission of monetary policy, building on the approach of Greenwald (2019) and using monetary policy shocks developed in Beckers (2020) to address endogeneity concerns. I find that the transmission of monetary policy to real business activity is amplified where the firm is subject to an interest coverage requirement, as higher interest rates have a direct effect in making the requirement more binding (and vice versa).…”

“…Author's calculations; Beckers (2020); Connect4; Morningstar Focusing on non-mining firms only, I find the estimates to remain virtually unchanged (Figure F1), suggesting that changes in the composition of covenants could potentially account for part of the weakness in non-mining investment observed over the 2010s (Debelle 2017;Lowe 2018;Dynan 2021). Applying the results from my sample to the full economy seems reasonable, given my sample is made up of large firms, and large firms account for a large proportion of non-mining investment (Dynan 2021).…”

Estimating the Effects of Monetary Policy in Australia Using Sign-restricted Structural Vector Autoregressions

“…Second, I consider imposing additional sign restrictions based on an existing 'proxy' for the monetary policy shock. The proxy is taken from Beckers (2020), who applies a variant of the approach in Romer and Romer (2004) to purge the cash rate of its systematic response to macroeconomic and financial conditions. This proxy has been constructed with the purpose of measuring monetary policy shocks, so it should be positively correlated with the 'true' monetary policy shock.…”

“…More broadly, this paper complements previous attempts to estimate the effects of monetary policy in Australia. Recent examples include Bishop and Tulip (2017) and Beckers (2020), who apply variations of the approach in Romer and Romer (2004) to purge the cash rate of anticipated changes. Earlier work tended to impose a system of zero restrictions sufficient to achieve point identification of impulse responses in an SVAR; examples include Brischetto and Voss (1999), Suzuki (2004), Berkelmans (2005) and Lawson and Rees (2008).…”