Smith Faculty Opinion Article

By Dr. John A. Haslem, Professor Emeritus of Finance E-MAIL WEB SITE

The 30 Seconds Outlook
March 15, 2010

The Taylor Rule discussed in a previous Outlook establishes the role of the Fed’s loose monetary policy leading up to the financial crisis:

1. “ Monetary excesses were the main cause of the crisis.”
2. “The loose monetary policy accelerated the housing boom and bust.”
3. “The boom and bust in the housing market would be expected to impact financial markets.”
4. “The boom and bust in the housing markets were amplified by sub-prime mortgages but also by packaging these loans into mortgage backed securities of great complexity with inadequate transparency.”

But, there is more to the downside of the Fed’s loose monetary policy. Bekaert, Hoerova, and LoDuca (Working Paper, February 2010) document a strong co-movement between the VIX Index, the option-based measure of implied volatility for the S&P 500 Index, and monetary policy. A strong positive correlation exists between real interest rates and future VIX levels. But, the relationship becomes significantly negative after 13 months and remains so for the medium term. This suggests loose monetary policy can be conducive to financial instability. These findings are eerily familiar.

Further, loose monetary policy decreases risk aversion in the medium term, but stock market volatility (uncertainty) is unaffected. Also, looser monetary policy follows periods of high uncertainty.

Bernanke’s work suggests that monetary policy’s effect is not strong enough to “pop a bubble.” However, if monetary policy increases risk taking in asset markets, his conclusion may not hold. But, monetary policy can increase risk aversion and affect real outcomes during crisis periods. Monetary policy thus has a role in reducing market ”fear” evidenced by unusually high VIX levels.

In summary, monetary policy that is too loose for too long decreases risk aversion in financial markets. This finding is also eerily familiar.

John A. Haslem