Aurora Borealis
1 August 2017 CFA Institute Journal Review

The Unintended Consequences of the Zero Lower Bound Policy (Digest Summary)

  1. Rich Wiggins, CFA
In the aftermath of the global financial crisis of 2007–2008, the US Federal Reserve aggressively pushed down short-term interest rates to promote an atmosphere of price stability and an economic environment conducive to sustainable economic growth. The authors discuss the impact of near-zero interest rates on financial institutions.

How Is This Research Useful to Practitioners?

Money market funds are significant investors in some credit markets, and the authors are among the first to provide micro-level evidence on the reaction of financial institutions to near-zero interest rates. But the real value of the authors’ research is its generalizability to other participants’ appetite for credit and liquidity risk. Life insurance companies write contracts containing guaranteed minimum nominal returns, but when inflation or real interest rates fall, reaching those nominal targets becomes harder. Similarly, pension funds strive to meet an assumed rate of return that puts them in an analogous reach-for-yield position that can lead them to take on more risk. This situation is particularly true when the compensation contracts of asset managers reward returns but do not penalize risk.

Another interesting discovery is that investors are twice as sensitive to fund performance in periods of lower interest rates as they are in normal times. The notion that both investors’ risk appetite and managers’ risk appetite can be meaningfully affected by operational and exogenous market influences is very interesting. The authors establish a potentially direct connection between the two.

How Did the Authors Conduct This Research?

Interest rates have an outsized impact on money market asset management firms, because there is a direct link between fund returns and subsequent fund flows. Near-zero interest rates affect the business model in two very strong and direct ways: Low yields prompt investor redemptions and reduce revenues for money market portfolios, because returns on the portfolio instruments fall short of the fees they would normally charge. Mutual funds pay investors a net-of-expenses return equal to the yield on investments less fund expenses. But when yields decline to the point where returns are negative, mutual funds are forced to waive their fees, boost their risk taking, and reach for yield—or exit the market because it is fundamentally unprofitable. The authors explore the impact of a zero-rate policy by examining the responses of various cross sections of the money fund industry to changes in interest rates, independent of interest rate level.

The zero lower bound policy was introduced in December 2008, so the authors explore money funds’ behavior three months and six months after Federal Open Market Committee (FOMC) meetings during which there was a meaningful change in interest rates or a forward guidance announcement. They pay particular attention to periods of profit stress when interest rate levels were around 1% and expenses remained nearly unchanged. The authors also compare both fund closures and fund creations of fund families that closed their money market funds with those of fund families that did not.

Abstractor’s Viewpoint

Most macroeconomic and asset-pricing models incorporate an assumption about risk appetite, so the topic is important even if money market funds are inherently boring. Fear gauges and measures of risk appetite are often cited in the media as factors influencing financial markets, but this topic is an example of the causality flowing in the opposite direction. In theory, a low appetite for risk translates into a higher cost of capital, but the authors suggest that a low cost of capital could trigger a higher risk appetite.

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