2.5 Credit spreads

Since the onset of the recent financial crisis, a rise in the perceived degree of risk associated with lending and borrowing has significantly widened the gap between the interest rate set by the Reserve Bank of New Zealand and the price of credit available to the wider economy. As a result, monetary policy has subsequently taken serious account of the effect of credit spreads on the behaviour of agents in the economy.

While the existence of a credit spread is not important to the running of fiscal policy simulations (since there is no hypothesised relationship between credit spreads experienced by the wider economy and discretionary fiscal policy) it is important to the estimation of the model. To exclude the effect of higher credit spreads would miss important information relevant to the monetary policy decision and the real interest rate faced by households and businesses.

The inclusion of credit spreads in the model presented here is based on a simple principle: the Reserve Bank is ultimately concerned with the interest rates paid by household and firms in the economy. So if the spread of interest rates experienced by agents in the wider economy over policy rates is higher than usual, this implies that the Bank would set policy rates lower than usual. Therefore, rather than targeting policy rates, in this model, the Bank takes credit spreads into account directly and targets an adjusted policy rate, described here as Effective Bank Rate, .

By extending the baseline New-Keynesian model of the economy to include a measure of credit spreads, Curdia & Woodford (2009) show that agents in the economy respond in a similar fashion to increases in borrowing rates arising from changes in the default risk premium as they would to an increase in Bank Rate.[17] Importantly, the C&W model shows that, so long as central bankers take credit spreads into account, the Taylor class of policy rules remains optimal in choosing the stance of monetary policy.

To construct a measure of the credit spread, I use a selection of quoted household borrowing and deposit rates and subtract from those the relevant reference rate of interest.[18] For example, I take the average interest rate quoted for a 2-year fixed-rate mortgage and subtract from this the two-year government bond rate. This gives the spread over expected policy rates at the relevant time horizon.[19]

In this paper, the model is presented in terms of deviations around a steady-state. Therefore, the credit spread series should also be expressed in terms of deviations around a steady-state. For simplicity, I assume that the steady-state credit spread is stationary around its long-run average value.

The evolution of the credit spread is given by equation 2.27,

      (2.27)

where cs is assumed to follow an autoregressive process that reverts to an equilibrium mean value of zero.[20]

The effective interest rate is defined as,

      (2.28)

where the coefficient, τ_cs, allows for the possibility of a rise in credit spreads affecting consumer behaviour more or less than a corresponding move in bank rate.

Credit spreads enter the model in two places: the IS relation and the Taylor rule. The real interest rate gap, which features in the IS relation, becomes,

      (2.29)

and Taylor rule becomes,

      (2.30)

The Taylor rule is augmented to allow the central bank to respond to deviations of the credit spread from its steady state. When the coefficient, δ_cs, is equal to unity, the Bank treats the increase in the credit spread as equivalent to an increase in bank rate. Values not equal to unity allow for a partial or excess response of policy rates to credit spreads. Since the bank's expectations are model consistent, the effect of the credits spread on the economy and the bank's policy response are constrained to be consistent with one another,

      (2.31)