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Thursday, September 30, 2010

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 aversion 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.”