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The Tail That Keeps the Riskless Rate Low

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  • Julian Kozlowski
  • Laura Veldkamp
  • Venky Venkateswaran

Abstract

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 reassess 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 into 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 reestimate the distribution and attach a higher probability to such an event recurring. As a result, even transitory shocks have persistent effects because once observed, the shocks stay forever in the agents’ data set. We show that our belief revision mechanism can help explain the persistent nature of the fall in risk-free rates.

Suggested Citation

  • Julian Kozlowski & Laura Veldkamp & Venky Venkateswaran, 2019. "The Tail That Keeps the Riskless Rate Low," NBER Macroeconomics Annual, University of Chicago Press, vol. 33(1), pages 253-283.
  • Handle: RePEc:ucp:macann:doi:10.1086/700895
    DOI: 10.1086/700895
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    Cited by:

    1. Julian Kozlowski & Laura Veldkamp & Venky Venkateswaran, 2020. "The Tail That Wags the Economy: Beliefs and Persistent Stagnation," Journal of Political Economy, University of Chicago Press, vol. 128(8), pages 2839-2879.
    2. Alessandro Cantelmo, 2020. "Rare disasters, the natural interest rate and monetary policy," Temi di discussione (Economic working papers) 1309, Bank of Italy, Economic Research and International Relations Area.
    3. Bassanin, Marzio & Faia, Ester & Patella, Valeria, 2021. "Ambiguity attitudes and the leverage cycle," Journal of International Economics, Elsevier, vol. 129(C).
    4. Thomas J. Carter & Xin Scott Chen & José Dorich, 2019. "Le taux neutre au Canada : mise à jour de 2019," Staff Analytical Notes 2019-11fr, Bank of Canada.
    5. Julian Kozlowski & Laura Veldkamp & Venky Venkateswaran, 2019. "The Tail That Keeps the Riskless Rate Low," NBER Macroeconomics Annual, University of Chicago Press, vol. 33(1), pages 253-283.
    6. Richard Berner, 2019. "Adaptive markets: financial evolution at the speed of thought by Andrew Lo," Business Economics, Palgrave Macmillan;National Association for Business Economics, vol. 54(1), pages 89-91, January.
    7. Mykola Babiak & Roman Kozhan, 2021. "Growth Uncertainty, Rational Learning, and Option Prices," CERGE-EI Working Papers wp682, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
    8. Paolo Mauro & Jing Zhou, 2021. "$$r-g," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 69(1), pages 197-229, March.
    9. Burçin Kısacıkoğlu, 2020. "Real Term Structure and New Keynesian Models," International Journal of Central Banking, International Journal of Central Banking, vol. 16(3), pages 95-139, June.
    10. Bassanin, Marzio & Faia, Ester & Patella, Valeria, 2019. "Ambiguity Attitudes, Leverage Cycle and Asset Prices," CEPR Discussion Papers 13875, C.E.P.R. Discussion Papers.
    11. Julian Kozlowski, 2019. "Tail Risk: Part 3, The Return on Safe and Liquid Assets," Economic Synopses, Federal Reserve Bank of St. Louis, issue 20, August.
    12. Maya Jalloul & Mirela Miescu, 2021. "Equity Market Connectedness across Regimes of Geopolitical Risks," Working Papers 324219805, Lancaster University Management School, Economics Department.
    13. Thomas J. Carter & Xin Scott Chen & José Dorich, 2019. "The Neutral Rate in Canada: 2019 Update," Staff Analytical Notes 2019-11, Bank of Canada.

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    More about this item

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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