The Tail That Keeps the Riskless Rate Low

Riskless interest rates fell in the wake of the financial crisis and have remained low. We explore a simple explanation: this recession was perceived as an extremely unlikely event before 2007. Observing such an episode led all agents to reassess macro risk, in particular the probability of tail events. Since changes in beliefs endure long after the event itself has passed, perceived “tail risk” remains high, generates a demand for riskless liquid assets, and continues to depress the riskless rate. We embed this mechanism into a simple production economy with liquidity constraints and use observable macro data, along with standard econometric tools, to discipline beliefs about the distribution of aggregate shocks. When agents observe an extreme adverse realization, they reestimate the distribution and attach a higher probability to such an event recurring. As a result, even transitory shocks have persistent effects because once observed, the shocks stay forever in the agents’ data set. We show that our belief revision mechanism can help explain the persistent nature of the fall in risk-free rates.