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The Effect of Monetary Policy on Credit Spreads

In this paper, we analyze the effect of monetary policy on credit spreads between yields on corporate bonds with different ratings over changing conditions in the economy. Using futures data on the fed funds rate, we distinguish between expected and unexpected changes in monetary policy. We find that unexpected changes in the fed funds rate do not have a significant effect on changes in credit spreads when we do not control for different conditions in the economy. We then distinguish between three different cycles in the economy: business, credit and monetary policy cycles. In line with predictions of imperfect capital market theories, credit spreads widen following an unexpected monetary policy tightening during bad times. On the other hand, credit spreads narrow following an unexpected monetary policy tightening during good times. We argue that this inverse relation is mainly due to the positive effect of unexpected monetary policy tightening on investors’ expectations about the future of the economy during good times. Several robustness tests suggest that our results are not due to possible endogeneity problems, lack of control variables or identification methodology for different cycles.