Measuring financial cycle time

Summary

Focus

Even though the Great Financial Crisis sparked interest in financial cycles, researchers and policymakers have yet to forge a workhorse model. One reason is the disagreement about key factors leading to the crisis. While some argue it resulted from a unique set of developments that exposed weaknesses in the financial regulatory system, others point to broad similarities across past boom-bust experiences. They infer from these similarities that cycles are an inherent feature of financially liberalised economies. We look at broad historical swings in financial cycles to weigh up these views.

Contribution

This paper adds a new perspective to the literature on empirical financial cycles. It highlights the recurring and inherent nature of swings in financial conditions, which result in costly booms and busts. However, this characterisation does not appear so obvious when looking at conventionally plotted historical data (that is, observed in calendar time). We shed light on the facts by distinguishing between financial cycles in calendar time and in what we call "financial cycle time".

Findings

Extending the methods pioneered by James Stock (1987) in his study of business cycles, we find that historical swings in the financial cycle exhibit statistical time deformation, which is time-varying. Changes in this gap between calendar time and financial cycle time are strongly associated with time-varying macrofinancial risk perceptions. Key risk indicators include the long-term real interest rate, inflation volatility and corporate credit spreads. The implications for statistical modelling, endogenous risk-taking economic behaviour and policy are highlighted. This evidence supports the view that financial cycles are a recurrent and inherent feature of the financial system, strengthening the case for macroprudential and monetary policies that lean against the wind.

Abstract

Motivated by the traditional business cycle approach of Burns and Mitchell (1946), we explore cyclical similarities in financial conditions over time in order to improve our understanding of financial cycles. Looking back at 120 years of data, we find that financial cycles exhibit behaviour characterised by recurrent, endogenous swings in financial conditions, which result in costly booms and busts. Yet the recurrent nature of such swings may not appear so obvious when looking at conventionally plotted time-series data (that is, observed in calendar time). Using the pioneering framework developed by Stock (1987), we offer a new statistical characterisation of the financial cycle using a continuous-time autoregressive model subject to time deformation, and test for systematic differences between calendar and a new notion of financial cycle time. We find the time deformation to be statistically significant, and associated with levels of long-term real interest rates, inflation volatility and the perceived riskiness of the macro-financial environment. Implications for statistical modelling, endogenous risk-taking economic behaviour and policy are highlighted.

JEL classification: E32, G01, F32, F34, E58, E71, D80

Keywords: financial cycles, continuous-time autoregressive models, time deformation, behavioural economics, endogenous risk-taking behaviour, central banking