Credit Spreads and Real Activity ∗ Philippe Mueller † London School of Economics First Draft : April 2007

This paper explores the transmission of credit conditions into the real economy. Specifically, I examine the forecasting power of the term structure of credit spreads for future GDP growth. I find that the whole term structure of credit spreads has predictive power, while the term structure of Treasury yields has none. Using a parsimonious macro-finance term structure model that captures the joint dynamics of GDP, inflation, Treasury yields, and credit spreads, I show that there is a pure credit component orthogonal to macroeconomic information that accounts for 50% to 65% of the forecasting power of credit spreads. The credit factor is highly correlated with the index of tighter loan standards, thus lending support to the existence of a transmission channel from borrowing conditions to the economy. Using data from 2006–2008, I capture the ongoing crisis during which credit conditions have heavily tightened. As of year-end 2008, the model predicts a contraction of −2% in real GDP growth for 2009, which is more pessimistic than concurrent forecasts available from surveys. JEL Classification: E43; E44; E47; G12.