Saturday, October 31, 2015
Monetary policy and reaching for yield - perhaps not happening as expected
Have the QE policies of the Fed worked? Many have just talked about the success of the Fed' policies through the counterfactual. Boy, the world would have been a lot worse if it did not engage in the unconventional policies like QE1, QE2, and QE3. Those on the opposite side of the spectrum argue that these policies have caused excessive risk-taking because firms have reached for yield. Unfortunately, for either of these arguments, there has not been a lot of empirical evidence to provide an answer. We now have some new evidence which is very insightful.
Garbiel Chodorow-Reich has presented "Effects of Unconventional Monetary Policy on Financial Institutions" in the latest Brooking Papers on Economic Activity.This may not be the definitive work on the subject, but it provides some useful analysis on the how Fed policy impacted financial firms and whether these firms changed their behavior in a zero rate environment.
The unconventional monetary policies had a strong positive impact in the 2008-2009 winter period for both banks and life insurance companies through creating an asset market environment that was repriced at higher levels. The legacy assets that were floundering from declines in 2007-08 were lifted higher which supported the balance sheet of these firms. This view is consitent with what everyone will say about the flood of liquidity after the September 2008 crisis period. The Fed acted like a good lender of last resort and saved the financial system through the actions of unconventional policies and TARP. However, the impact of expansionary policy in 2010-013 was more mixed. There was not a negative effect but the sizable positive impact seen in the winter of 2008-09 was diminished.
The author looked at whether fund managers reached for yield during the post crisis period. The was clear evidence that this was true for money market funds which had high cost structures. They needed to offset their higher fees and costs when rates moved to zero. Private defined benefit funds also increased their risk taking in 2009, but this behavior was largely dissipated by 2012. The author concludes that there may have ben more risk-taking in the initial period after the crisis but this riskier behavior was not seen later in the analysis. This is consistent with the idea that there has been a smaller impact from monetary policy as we have moved further from the crisis.
I found this work very useful for helping me think about risk-taking behavior by financial institutions and the evidence presented was compelling. I am convinced that the impact of unconventional monetary policy has dissipated, but I still believe that the zero rate environment has changed risk-taking behavior for both consumer and businesses. Savers are changing their work behavior and retirement plans. Financial institutions have had to change their activity mix to make up for the fact that their loan spreads may be lower and they are stuck with excess deposits.
Incentives matter and change behavior. If you change the time value of money, behavior will change. We just have to get a better handle on the measurement. Keeping rates low and stable for such a long time will change behavior, we just do not know exactly how.