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A Black Swan in the Money Market

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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.

Suggested Citation

  • John B. Taylor & John C. Williams, 2008. "A Black Swan in the Money Market," Working Paper Series 2008-04, Federal Reserve Bank of San Francisco.
    • Handle: RePEc:fip:fedfwp:2008-04
    DOI: 10.24148/wp2008-04
    Note: PDF date: First version: February 21, 2008. Updated: April 2, 2008.
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    Keywords

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    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
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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