The Next Bubble

Via John Taylor, a recent study has found empirical evidence that a “lax monetary policy” is correlated with an increased appetite for risk-taking. From the study’s abstract:

We document a strong co-movement between the VIX, the stock market option-based implied volatility, and monetary policy. We decompose the VIX into two components, a proxy for risk aversion and expected stock market volatility (“uncertainty”), and analyze their dynamic interactions with monetary policy in a structural vector autoregressive framework. A lax monetary policy decreases risk aversion after about five months. Monetary authorities react to periods of high uncertainty by easing monetary policy. These results are robust to controlling for business cycle movements. We further investigate channels through which monetary policy may affect risk aversion, e.g., through its effects on broad liquidity measures and credit.

to which Dr. Taylor adds:

The bottom line of this empirical research, as the authors put it, is that “lax monetary policy increases risk appetite (decreases risk aversion) in the future, with the effect lasting for about two years and starting to be significant after five months.” Their result is important to the policy debate because such monetary policy has been “cited as one of the contributing factors to the build up of a speculative bubble prior to the 2007-09 financial crisis.”

Here’s an exercise for you. Let’s assume that the findings of the study are true. Is the current policy of the Fed sufficiently lax that it would provoke the response found in the study? If not, why not? If it would, what would the likely outcome be?