Risk‐taking channel of monetary policy

• DOI: http://doi.org/10.1111/fima.12256
• Date: 01 September 2019
• Author: Hyun Song Shin,Arturo Estrella,Tobias Adrian
• Published date: 01 September 2019

DOI: 10.1111/fima.12256

ORIGINAL ARTICLE

Risk-taking channel of monetary policy

TobiasAdrian1Arturo Estrella2Hyun Song Shin3

1International Monetary Fund,Washington, DC

2Rensselaer PolytechnicInstitute, Troy,

New York

3Bank for International Settlements, Basel,

Switzerland

Correspondence

TobiasAdrian, International Monetary Fund,700

19thStreet, NW, Washington, DC 20431.

Email:tadrian@imf.org

Abstract

One of the most robust stylized facts in macroeconomics is the fore-

casting power of the term spread for future real activity. We pro-

pose a possible causal mechanism for the forecasting power of the

term spread, deriving from the balance sheet management of finan-

cial intermediaries and the “risk-taking channel of monetary pol-

icy.” Monetary tightening leads to the flattening of the term spread,

reducing net interest margin and credit supply.We provide empirical

support for the risk-taking channel.

KEYWORDS

credit supply, net interest margin, term spread

1INTRODUCTION

A traditional view in monetary economics is that interest rates are transmitted via the money demand function, and

that the level of interest rates affects real consumption and investment. However, beginning in the mid-1980s, the

relationship between money and economic activity became highly unstable as rapid changes in the financial system

started to change the nature and composition of monetary aggregates.

Asa result, theories of monetary transmission that explicitly include quantities have lost prominence. Instead, atten-

tion has turned to expectations-based channels of monetary policy, which emphasize the expectationstheory of the

yield curve and the role of expectedfuture short-term interest rates in determining the long-term interest rate.

In this paper,we re-examine the transmission of monetary policy to the real economy by connecting two strands of

literaturethat have thus far been largely separate: the forecasting power of the term spread for future real activity and

the balance sheet management of financial intermediaries.

One of the most robust features of macroeconomics is the forecasting power of the term spread for future real

activity, with an inverted yield curvebeing a harbinger of recessions within a 12- to 18-month period (see Estrella &

Hardouvelis, 1989, 1991; Harvey,1989; Stock & Watson, 1989, 1993). Since 1961, 7 recessions have occurred, each

of which has been preceded by an inversion of the yield curve. Conversely, there has only been one episode in the

United States since 1961 where an inversion of the yield curvein 1966 was not followed by a recession (however, that

episode was followed by an increase in unemployment). In addition, the yield curve has been demonstrated to pre-

dict recessions even prior to 1961 (Bordo & Haubrich, 2004), and across countries (Bernard & Gerlach, 1996; Estrella,

The views expressedin this paper are those of the authors and do not necessarily represent those of the International Monetary Fund or the Bank for Inter-

nationalSettlements.

c

2018 Financial Management Association International

Financial Management. 2019;48:725–738. wileyonlinelibrary.com/journal/fima 725