President's Message: On Spreads and Recessions
As borrowers, we know that the interest rates we pay vary with the market's assessment of the risk that we might default on our obligations. This is why interest rates on U.S. government securities are lower than rates on private securities of the same maturity: We assume that the government will not renege on its promise. Likewise, rates on lower-rated private securities, like Baa-rated corporate bonds, are higher than those on higher-rated Aaa bonds.
The spreads between private and government securities and between Baa- and Aaa-rated bonds typically rise whenever the economy moves into recession. Why? Because as a firm's earnings decline, so too does its ability to service its debt. The less creditworthy the borrower and the deeper the recession, the wider the spreads among interest rates.
A wide range of closely watched rate spreads, including the spreads between Baa- and Aaa-rated securities, increased dramatically from July to September of last year. These widening spreads led to increased speculation of economic recession. It is important to note, however, that when the widening of these rate spreads is due to recession, the recession is already under way. Although I have learned never to say "impossible," it seems unlikely that a recession is already under way. Moreover, I know of no case where the period leading to recession was characterized by low-to-declining inflation, declining interest rates and high-and-rising money growth—all of which we have now.
A more reasonable explanation for the recent widening of rate spreads is the mid-August announcement that Russia would default on—technically, restructure—its sovereign debt. Historically, rate spreads have widened on news that caused investors to reassess risks. Some financial market disturbances affect a narrow range of rate spreads—for example, the Penn-Central Railroad bankruptcy declaration in 1970 and the near collapse of Continental Illinois Bank in 1984. Other shocks, like the stock market crash of 1987, affect a broader spectrum of spreads.
It appears to me that the Russian default led investors to think more carefully about the risks in the marketplace and to question whether existing spreads were adequate to compensate for those risks. When rate spreads widen, the danger is that borrowers who previously would have qualified readily for funds will find it more difficult to obtain them. If spreads remain high for an extended period of time, the effect on the economy can be substantial. I am inclined to think that this financial market disturbance, like many before it, will be temporary. Indeed, spreads have narrowed substantially since last October. However, we at the Fed must continue to watch this situation closely.
The Regional Economist offers insights on regional, national and international issues. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.