Working Paper Series no. 134: The Fed and the Question of Financial Stability: An Empirical Investigation

Abstract

This paper shows that the Fed reacts to change in spreads between corporate bond yields and government bond yields over and beyond their information content on future inflation and future activity. This result, obtained in a GMM framework, is confirmed by simulation methods. Moreover, when credit spreads are on the rise, the probability that the Fed will make a large error in forecasting output and inflation increases. In this sense, the Fed's preemptive easings - despite their short-term costs, as monetary policy may become too accommodative - are a way to take into account the downside risks to the baseline forecasts and insure the economy against increasing uncertainty and the likelihood of a very costly extreme event.

Thierry Grunspan
October 2005

Classification JEL : E58, E44, C14, C52.

Keywords : Credit Spreads, Taylor Rule, Non-parametric estimation, Green book forecasts.