Flight to Safety in Business cycles

FTS in Business cycles examines the dynamic effects and empirical significance of Flight to Safety (FTS) shocks in the context of US business cycles. FTS represents a sudden preference for safe over risky investments and contains important information on agents’ time-varying risk-aversion and their expectations for future economic activity. This analysis presents an identification for FTS shocks using vector autoregressions (VAR). Sign restrictions are applied, while controlling for monetary policy and productivity shocks, on the price differential series between stocks and bonds in the US. Identified positive disturbances to this differential series are characterised as FTS shocks. The business cycle impact of FTS is calculated by applying the structural VAR model to the US economic data from 1955 to 2019. A sudden increase in risk aversion, which is displayed through the FTS shocks in the identified VAR model, has played a significant role in keeping investments low in the US. FTS shocks explain more than sixty per cent of the variation in US investments and they explain a higher proportion of macroeconomic fluctuations in periods around the Global financial crisis. This is a significant linkage when compared against the results of DSGE models enriched with time-varying risk-premium and investment technology. FTS also comes up ahead of news shocks in providing early signals of shifts in total factor productivity. This analysis is consistent with other comparable high-frequency, kernel-based measures of identifying FTS. The results also reveal the asymmetric impact on the business cycle of Flight to Safety and its complement Flight to Risk phenomenon. This asymmetry lends support to pursuing a cyclical risk-aversion driven view of business cycles.