Does the U.S. Federal Reserve Consider the Credit Cycle Theory When Trying to Predict Recession?

Abstract

The credit cycle theory states that credit build-ups and their subsequent crashes are the common cause of recessions. If true, this theory could be used to both predict and prevent future recessions. However, it is unclear if policymakers do in fact take the theory into account when crafting monetary policy. Using the U.S. Federal Reserve (the Fed) as a case study, this paper seeks to answer if policymakers consider the credit cycle theory when attempting to predict recessions and determine optimal monetary policy. This paper analyzes Federal Open Market Committee minutes from meetings prior to four previous recessions: the Savings and Loan Crisis, the Dot-Com Bubble, the Great Recession, and the Covid Recession. The results indicate that the Fed did not begin to consider the credit cycle theory when implementing monetary policy until after the Great Recession. Credit was not addressed prior to the Savings and Loan Crisis and was only substantially mentioned on the eve of the Dot-Com Bubble and the Great Recession. This indicates that instead of continually discussing credit, the Fed was only concerned with credit when it began to tighten. While it did mention credit build-up, especially before the Great Recession, the Fed did not adjust its monetary policy accordingly. Instead, it primarily adjusted policy to manage inflation. However, after the Great Recession, the Fed began adhering more closely to the credit cycle theory both in terms of what was discussed in each meeting, as it consistently discussed credit, and how it implemented monetary policy.