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A Black Swan in the Money Market

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  • John B. Taylor
  • John C. Williams

Abstract

At the center of the financial market crisis of 2007-2008 was a highly unusual jump in spreads between the overnight inter-bank lending rate and term London inter-bank offer rates (Libor). Because many private loans are linked to Libor rates, the sharp increase in these spreads raised the cost of borrowing and interfered with monetary policy. The widening spreads became a major focus of the Federal Reserve, which took several actions -- including the introduction of a new term auction facility (TAF) --- to reduce them. This paper documents these developments and, using a no-arbitrage model of the term structure, tests various explanations, including increased risk and greater liquidity demands, while controlling for expectations of future interest rates. We show that increased counterparty risk between banks contributed to the rise in spreads and find no empirical evidence that the TAF has reduced spreads. The results have implications for monetary policy and financial economics.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13943.

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Date of creation: Apr 2008
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Publication status: published as John B. Taylor & John C. Williams, 2009. "A Black Swan in the Money Market," American Economic Journal: Macroeconomics, American Economic Association, vol. 1(1), pages 58-83, January.
Handle: RePEc:nbr:nberwo:13943

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  1. Vasco Curdia & Michael Woodford, 2008. "Credit Frictions and Optimal Monetary Policy," Discussion Papers 0809-02, Columbia University, Department of Economics.
  2. Joe Peek & Eric S. Rosengren, 1998. "Determinants of the Japan premium: actions speak louder than words," Working Papers 98-9, Federal Reserve Bank of Boston.
  3. Covrig, Vicentiu & Low, Buen Sin & Melvin, Michael, 2004. "A Yen is Not a Yen: TIBOR/LIBOR and the Determinants of the Japan Premium," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(01), pages 193-208, March.
  4. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
  5. Anderson, Richard G & Rasche, Robert H, 1982. "What Do Money Market Models Tell Us about How to Implement Monetary Policy?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 14(4), pages 796-828, November.
  6. John P. Judd & John L. Scadding, 1982. "What do money market models tell us about how to implement monetary policy: reply," Working Papers in Applied Economic Theory 108, Federal Reserve Bank of San Francisco.
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