Credit Spreads and How Lax Is Monetary Policy?

All eyes have been on the housing market as the trigger for the financial crisis, but we’re all aware that there are other potential “triggers” for additional distress: auto loans and credit cards. In addition, spreads are not everything — levels of real interest rates matter as well.

Let’s start with credit spreads. Here are some pictures, courtesy of Deutsche Bank.

spread1.pngChart 5 from Mayer, Hooper, Slok and Wall, “From financial crisis to economic crisis?” Global Economic Perspectives (October 15, 2008).

spread2.gifChart 6 from Mayer, Hooper, Slok and Wall, “From financial crisis to economic crisis?” Global Economic Perspectives (October 15, 2008).These graphs remind us (or at least me, since readers are probably well aware of this already) that subprime is not just in housing [0]. And that perceived risk is rising in these markets as well. While these markets need not follow the path of housing subprime, it strikes me the that a sharp downturn will tend to widen these spreads, holding all else constant.

At this juncture, I want to switch gears. At a presentation I gave recently, one audience member asked what constituted lax monetary policy. I think that’s a relatively easy question to answer when market conditions are normal (so that the interest rates that firms borrow at are linked in a stable fashion to the the policy rate): it’s when the the policy rate is less than that indicated by some real-time data based Taylor rule. (Admittedly, if one believes monetary policy should target asset prices, then it’s all a lot less clear (e.g., [1]).)

But conditions are not, by any means, normal. And it turns out that many interest rates — on variable rate mortgages, HELOCs, etc., are linked to dollar Libor [2]. That prompted me to see what real Libor looked like. Here’s the picture.

spread3.gifFigure 1: Three month dollar Libor minus lagged 12 month inflation (calculated using headline CPI). 12 month inflation for Sep (Oct) assumed to be 5.2%(5%). Source: IMF International Financial Statistics, Economagic, Bloomberg, and BLS via St. Louis Fed FRED II. This is a pretty sobering picture. Despite the repeated cuts in the policy rate, the (real) interest rate relevant for a lot of the economy is about the same as that in December 2007 (with the usual caveats that the ex post lagged 12 month interest rate is probably a poor proxy for the future expected 3 month inflation rate).

For more on Libor, see Odd Numbers and Mish.

Originally published at Econbrowser and reproduced here with the author’s permission.