The Unintended Consequences of the Zero Lower Bound Policy

by Marco Di Maggio and Marcin Kacperczyk

Overview — In the aftermath of the financial crisis of 2007-2008, the United States Federal Reserve took an unprecedented decision to lower short-term nominal interest rates to zero, a policy commonly known as zero lower bound policy. This study shows that the policy adversely affected an important part of the shadow banking system, money market funds, whose returns are linked to the Fed funds rate. During times of unusually low interest rates, fund managers tended to increase their portfolios’ risk. The policy also triggered a reduction in capital supply to financial firms and large corporations and increased the financial markets’ exposure to costly runs and defaults.

Author Abstract

We study the impact of the zero lower bound interest rate policy on the industrial organization of the U.S. money fund industry. We find that in response to policies that maintain low interest rates, money funds change their product offerings by investing in riskier asset classes, are more likely to exit the market, and reduce the fees they charge their investors. The consequence of fund closures resulting from interest rate policy is the relocation of resources in affected fund families and in the asset management industry in general, as well as decline in capital of issuers borrowing from money funds.