Sugar Mountain: ...Itamar Drechsler, Alexi Savov, and Philipp Schnabl's "Model of Monetary Policy and Risk Premia" ... addresses a very important issue. The policy and commentary community keeps saying that the Federal Reserve has a big effect on risk premiums by its control of short-term rates. Low interest rates are said to spark a "reach for yield," and encourage investors, and too big to fail banks especially, to take on unwise risks. This story has become a central argument for hawkishness at the moment. The causal channel is just stated as fact. But one should not accept an argument just because one likes the policy result.
Nice story. Except there is about zero economic logic to it. The level of nominal interest rates and the risk premium are two totally different phenomena. Borrowing at 5% and making a risky investment at 8%, or borrowing at 1% and making a risky investment at 4% is exactly the same risk-reward tradeoff. ...
OK, enter Drechsler, Savov, and Schnabl. They have a real, economic model of the phenomenon. That's great. We may disagree, but the only way to understand this issue is to write down a model, not to tell stories. ...
Read the paper for more. I have come to praise it not to criticize it. Real, solid, quantiative economic models are just what we need to have a serious discussion. This is a really important and unsolved question, which I will close by restating:
Does monetary policy, by controlling the level of short term rates, substantially affect risk premiums? If so, how?
Of course, maybe the answer is "it doesn't."
[See the original post for the technical arguments and "money illusion" intuition for the results in the paper. This has been a key argument behind the call to increase the Fed's target rate now rather than later, so it's an important issue.]