The Tail that Keeps the Riskless Rate Low

Working Paper No. 24362 Riskless interest rates fell in the wake of the financial crisis and have remained low. We explore a simple explanation: This recession was perceived as an extremely unlikely event before 2007. Observing such an episode led all agents to re-assess macro risk, in particular, t...

Full description

Saved in:
Bibliographic Details
Published in:NBER Working Paper Series 2018-02, p.24362
Main Authors: Kozlowski, Julian, Laura Veldkamp Venky Venkateswaran
Format: Article
Language:English
Subjects:
Datasets
Debt financing
Econometrics
Economic conditions
Economic crisis
Economic models
Economic theory
Government bonds
Interest rates
International finance
Liquid assets
Monetary policy
Probability
Rates of return
Recessions
Securities prices
Citations: Items that cite this one
Online Access:Get full text
Tags: Add Tag
No Tags, Be the first to tag this record!
Description
Summary:Working Paper No. 24362 Riskless interest rates fell in the wake of the financial crisis and have remained low. We explore a simple explanation: This recession was perceived as an extremely unlikely event before 2007. Observing such an episode led all agents to re-assess macro risk, in particular, the probability of tail events. Since changes in beliefs endure long after the event itself has passed, perceived tail risk remains high, generates a demand for riskless, liquid assets, and continues to depress the riskless rate. We embed this mechanism in a simple production economy with liquidity constraints and use observable macro data, along with standard econometric tools, to discipline beliefs about the distribution of aggregate shocks. When agents observe an extreme, adverse realization, they re-estimate the distribution and attach a higher probability to such events recurring. As a result, even transitory shocks have persistent effects because, once observed, the shock stays forever in the agents' data set. We show that our belief revision mechanism can help explain the persistent nature of the fall in the risk-free rates.
ISSN:0898-2937
DOI:10.3386/w24362