Financial Business Cycles
Importance of Financial Business
• This chapter is not usually part of
macroeconomics or business cycle texts, but is
included here for two main reasons.
• 1. Since the causes of business cycles are
increasingly dominated by financial variables, it
is useful to understand what cyclical patterns
• 2. It is important for business managers to
understand what economic variables affect
movements in bond and stock prices, although
obviously the emphasis here is on longer-run
relationships rather than short-term trading.
Cyclical Patterns of Monetary and
• We have not said much about the money supply
in recent chapters, even though the importance
of financial variables has been emphasized.
• Since the deregulation of the banking sector in
1982, changes in the money supply have not
been closely correlated with changes in either
real growth or inflation.
• Instead, fluctuations in loans and credit
outstanding have become more important
Loans and Consumer Credit
• Loans and credit outstanding are either coincident or
lagging indicators, reflecting borrowing decisions that are
made for other reasons, and in that sense are not an
endogenous factor causing business cycle fluctuations.
• Nonetheless, in 1980 and in 1990, changes in credit
conditions – the imposition of outright credit controls and
much more severe regulations for banks – were major
causes of recessions in those years. This emphasizes
the degree to which the economy cannot continue to
expand without adequate supplies of consumer and
Cyclical Patterns in the Yield
• We have already noted several times that an
inverted yield spread is always followed by a
recession the next year. That is one of the few
business cycle relationships that remained intact
• When the yield spread becomes inverted, banks
would rather purchase Treasury securities than
offer loans, and the resulting contraction in credit
results in declines in credit-sensitive
components of GDP.
Inverted Yield Curve – Good Idea
• In that case, maybe the Fed should try to
avoid an inverted yield curve. Or
conversely, maybe that is a safety valve
that keeps recessions short and mild
instead of developing into extended
periods of stagnation or even depression.
Good or Bad Idea, Slide 2
• To review, the yield curve inverts when the Fed
raises interest rates enough that investors start
to believe the demand for loanable funds will
soon decrease enough – either because of
lower inflation and or lower real GDP – to push
bond yields lower and prices higher.
• If the Fed tightened but the yield spread did not
narrow, that would be a signal that investors
expected even higher inflation ahead. Yet if the
Fed did not tighten, that would send an even
clearer signal to investors that the Central Bank
had abandoned its duty to keep inflation low.
Good or Bad Idea, Slide 3
• The best way to keep the yield curve from
inverting is for the Fed to act with alacrity
when overheating appears probable, and
raise the funds rate sooner rather than
later. In 1994, the Fed acted quickly, and
while the economy slowed down, it did not
head into recession, In 1999 and 2000,
the Fed acted much more sluggishly, and
an inverted yield curve developed,
followed by a recession.
Good or Bad Idea, Slide 4
• Many reasons have been suggested – after the
fact, of course – why the Fed failed to tighten in
enough in the late 1990s. Inflation remained
low, productivity growth was accelerating, and
the world financial situation appeared tenuous.
Cynics claimed Greenspan did not want to
tighten in an election year. Whatever the precise
reasons, it now seems clear that the U.S.
economy would have been better off with earlier
tightening and a less explosive stock market
Cyclical Pattern of Stock Market
• Obviously we don’t have a secret formula for
beating the market. The logic of this section is
that (a) stock prices have an important impact on
capital spending, (b) to a certain extent, stock
prices are affected by cyclical variables, notably
interest rates and profits, and (c) stock prices
can generally be expected to fluctuate in a
manner that will have some impact on the
overall pattern of business cycles.
Impact of Stock Prices on Capital
• When the P/E ratio rises, the cost of equity
capital declines, hence boosting capital
• Also, a rising P/E may signify an improvement in
business optimism, or a technological boom,
indicating an increase in the MPK.
• In that sense, the stock market impacts both
sides of the fundamental relationship affecting
capital spending decisions.
Determinants of Stock Prices
Federal budget surplus or deficit
Other factors determining expected rate of
• Foreign saving and investment
• Random and exogenous events (9/11, Persian
Gulf Wars, Enron, etc.)
• Tax rate on capital gains and dividends relative
to rates on other personal and corporate income
Focusing on the Risk Factor
• Difference between the price/earnings (P/E) ratio
and the Aaa corporate bond rate is the “risk”
factor. That depends on all the other elements
listed on the previous slide.
• Since 1982, the risk factor has been between
2% and 4%, meaning that the growth rate of
earnings would be 2% to 4% above the bond
rate. Before 1982, the risk factor generally
averaged about 6%.
Determinants of the Risk Factor
• The risk factor rises when inflation rises and
when the budget deficit ratio rises.
• It declines when foreign saving and investment
increases relative to GDP
• Although not part of the risk factor, the P/E rises
when the maximum tax rate on capital gains
declines relative to the tax rate on other types of
income. A cut in the maximum rate on dividends
also boosts the P/E ratio.
• Of course there are bubbles from time to time.
They are unpredictable, and while it becomes
increasingly obvious the market is overvalued,
no one really knows at the time when it will turn
around. They just tell you later that they knew.
• Debate continues on whether the Fed should
step in more vigorously and keep these bubbles
from forming. How could it do that? Very
simply: raise the margin rate for purchasing
stocks. However, some fear that would be a
The Stock Market As Part of the
• Leaving aside bubbles, the general cyclical
relationship of the stock market, capital
spending, and overall economic performance
can be summarized as follows.
• The Fed reduces interest rates and increases
credit availability shortly after a recession gets
• Most of the time, in the absence of specific
exogenous forces to the contrary, the stock
market reverses course as starts to rise again
Stock Market Cycle, Slide 2
• The increase in stock prices is one of the factors
boosting capital spending, which helps to get the
• As profits rise, and the MPK increases, higher
stock prices also reduce the cost of equity
capital, thereby strengthening the recovery.
• When the economy begins to overheat, interest
rates rise, reducing stock prices. After the
normal lag, capital spending starts to decline.
Stock Market Cycle, Slide 3
• But suppose interest rates do not rise.
The stock market boom turns into a
bubble, and the increase in capital
spending eventually creates excess
capacity. A recession ensues anyhow.
• Seen in that light, it would be better for the
Fed to tighten substantially when signs of
a bubble start to appear even if inflation
has remained low and stable.