New Evidence Shows that Low Interest Rate Led To Yield Search

New empirical research establishes a strong relationship between very low interest rates set by the Fed, as in the period 2002-2005, and a risk-taking search for yield. This policy-induced lessening of risk aversion has been emphasized by Raghu Rajan and others as a key factor bringing on the financial crisis. The new empirical support for this view is reported in the working paper “Risk, Uncertainty and Monetary Policy” by Geert Bekaert, Marie Hoerova, and Marco Lo Duca.

The basic evidence is the pattern of correlations over time which can found by looking carefully through the following bar graphs and table drawn from the paper.

The bar graphs show the correlation between market volatility, measured by VIX, and the interest rate set by the Fed, measured by RERA—the federal fund rate minus the inflation rate. The two columns of five-digit numbers in the table labeled lead and lag are the values of the correlations shown in the bars. (VIX, of course, is the implied volatility of the S&P 500. The identifier LVIX is used because they actually look at the log of VIX).

The bar graph on the left (and the first column of numbers) shows the correlation coefficients between the VIX and values of the federal funds rate at previous months going back into the past from 1 month to 36 months. For example, the correlation between the VIX and the federal funds rate 12 months earlier is 0.5057. Observe that these correlations are all positive and significant, evidence that lower interest rates are associated with lower future values of the VIX, or less risk aversion as explained in the paper. In this sense, low interest rates tend to lower risk version and high interest rates raise it. In other words the low rates cause a search for yield with a willingness to take on more risk.

The bar graph on the right (and the second column of numbers) shows the correlation coefficients between the VIX and values of the federal funds rate at varying months going into the future. After the first few months, these correlations are negative and significant indicating that the Fed tends to react to high levels of volatility by lowering interest rates.

The bottom line of this empirical research, as the authors put it, is that “lax monetary policy increases risk appetite (decreases risk aversion) in the future, with the effect lasting for about two years and starting to be significant after five months.” Their result is important to the policy debate because such monetary policy has been “cited as one of the contributing factors to the build up of a speculative bubble prior to the 2007-09 financial crisis.”

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

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