The Tail that Keeps the Riskless Rate Low
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.
We thank Jonathan Parker, Marty Eichenbaum and Mark Gertler for helpful comments and suggestions. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
I have visited or lectured at the following institutions, where I have received an honorarium and/or have been paid travel expenses:
EIEF, Rome, Italy, research visitor.
Federal Reserve Bank of New York, US. As consultant to the Research Department.
Federal Reserve Bank of Minneapolis, US. As consultant to the Research Department.
Goldman Sachs, as a GMI fellow.
Standard & Poors, one-time honorarium.
University of California at Los Angeles, as a guest Ph.D. lecturer
I also receive a salary from Elsevier as an editor of the Journal of Economic Theory.