The Impact of the FOMC's Monetary Policy Actions on the growth of Credit Risk: the Monetary Policy - Liquidity Paradox

Credit risk is influenced by interest rates and market liquidity. This paper examines the direct and indirect impacts of unexpected monetary policy shifts on the growth of corporate credit risk, with the aim of quantifying the size and direction of the response. The results surprisingly indicate that monetary policy and liquidity impulses move counter to each other in their effects on credit risk ("The monetary policy-liquidity paradox"). The analysis indicates that while contractionary monetary policy creates tight money which subsequently leads to a slowing in the growth of credit risk and a reduction of liquidity in credit markets, reduced liquidity indirectly affects credit risk by accelerating its growth. The net effect of these transitory opposing forces generates the final impact on credit risk. An unexpected policy shifts is captured via a combination of the forward Fed fund rate curve and the Fed's FOMC policy announcements. Following the approach of Bernanke and Kuttner (2005), Hausman and Wongswan (2006) who examined asset prices under FOMC announcements, the study found that the estimated credit risk responses to FOMC announcements vary across credit qualities. Hence the analyses indicates that a typical unanticipated 25 basis point cut in the target fed funds rate generally resulted in an acceleration in the growth of credit risk by 0.50 percent for AAA rated corporate grade debt, and by 3.5 percent for BB rated corporate debt. Moreover, the study found a direct effect of the FOMC's policy instrument on market liquidity which had a significant effect on the growth in credit risk. The results indicate that a 1 percentage point increase in liquidity for AAA and CCC rated bonds resulted in a 0.7% and 52.45% decrease in the rate of growth in credit risk respectively.