Scott Sumner  

Interest on reserves and stock prices in 2008

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I did a recent post criticizing Bernanke's defense of paying interest on reserves. This policy was introduced in October 2008, and even the Fed viewed the policy as contractionary in intent. Indeed Susan Woodward and Robert Hall called the Fed's explanation a "confession of the contractionary effect of the reserve interest policy". The term 'confession' is rather telling, as it implicitly pushes back against the widespread view that the Fed was doing all it could in 2008 to stimulate the economy. Today I'd like to discuss the market view of IOR.

Back in 2010, Louis Woodhill suggested that the Fed announcement of interest on reserves, as well as two subsequent increases in IOR, had a very negative effect on the stock market:

A valid way to gauge whether events are "good" or "bad" for the economy is to look at the stock market's reaction to them. The day that Lehman Brothers collapsed, the S&P 500 went down 4.71%. Three days later (i.e., at the fourth market close after the event), the S&P 500 was down by a total of 3.61% from its pre-Lehman close.

At the time of the Fed's IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.


I have some serious doubts about Woodhill's way of doing event studies, particularly the four-day windows for each shock. But before getting into interpretation, let's do some math:

1. If we take the three negative IOR shocks cited by Woodhill, and look at the four-day windows that he describes, the declines in the S&P500 are 17.22%, 11.11%, and 8.60%. That adds up to 36.93% decline. But there is a compounding factor that (I think) reduces the total declines to about 32.75% (someone tell me if my math is wrong.) The intuition is that two consecutive 10% drops at up to 19%, not 20%.

2. Of course 2008 was a catastrophic years for the stock market, as this is when the Great Recession got going. The total decline in the S&P500 from December 31, 2007 to December 31, 2008 was 38.5%.

3. Thus the overwhelming majority of the stock market decline of 2008 took place in twelve trading days, immediately following three contractionary IOR announcements, and only a small part of the decline occurred during the other roughly 240 trading days.

What can we make of all this? Let me start by criticizing Woodhill, then defend him, and then give you my own view.

Let's start with the four-day windows. In an event study, a one-day window would be more appropriate. Why should the market reaction have taken four days? That time frame seems cherry-picked. Yes, even the single day drops were pretty large, much larger than a normal single day movement in the S&P500. But this was a very tumultuous period for the economy and the stock market, and large daily moves were pretty common in late 2008. So this is not statistically significant.

If I were to defend Woodhill I'd point to the fact that interest on reserves was a new and unfamiliar policy. It was not well understood by the markets. Indeed it wasn't even well understood by the Fed (which is why adjustments had to be made in October 22 and November 5, to make the policy more effective.) The Fed certainly wasn't loudly publicizing the fact that it was contractionary, you had to read the fine print. Perhaps the markets noticed the effects of IOR were contractionary. Thus over a period of several days they noticed monetary conditions tightening as banks were less anxious to move excess reserves out into the real economy, given that they were now earning more interest on excess reserves.

And yes, 2008 was a very volatile period for stocks, but a pretty big share of that volatility came in the twelve trading days cited above, when most of the total decline of 2008 occurred. So IOR may well have caused some of that volatility.

On the technical question of event studies, my views are somewhere in between, but a bit closer to those of Woodhill's critics. I'm not comfortable with the four-day windows on stock prices. I also recognize the extreme volatility of stock prices in 2008, having seen the same thing in my study of the Great Depression.

However I still put some weight on Woodhill's argument. In the 1930s, some of the very biggest stock price movements occurred immediately after monetary shocks. Thus the largest 2 day stock rally in American history occurred right after Hoover announced a change in gold policy that would lead to 1932's QE policy, and the next day Congress signaled its approval. There are too many such "coincidences" to be dismissed.

And suppose you are one of the Fed people who think that IOR helped the Fed to achieve its 2008 policy objectives. The fact that almost the entire stock market crash of 2008 occurred in just a few days after these three IOR announcements certainly doesn't give much reason to think IOR helped the economy.

For what's it's worth, I think there's about a 10% chance that Woodhill is basically right, in the sense that at least half of that 32.75% stock decline was linked to tighter money, particularly IOR. But that's still really bad news for IOR! Suppose you were told that some foreign policy move would lead to a 10% chance of a nuclear exchange with North Korea---would you be reassured that 10% is a low probability?

The Great Recession is the economic equivalent of a major foreign policy disaster. If there's even a 10% chance of IOR having caused this disaster, that's really bad.

I also think there's about a 50% chance that at least half of the stock declines over the three one-day windows were due to IOR. This is partly because in later years we saw IOR (including negative IOR) clearly impacting stock prices in various countries. And even those three one-day windows add up to a bit over 15%, or slightly less with compounding. That's still huge! How would you feel if the Dow fell 3000 points in the next three days?

So even in a world where Woodhill is only half right, or even 25% right, he's still basically right. Interest on reserves was a huge policy mistake. And I think there's at least an even chance that he is at least 25% right.

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Update: Commenter "dlr" presents some very powerful counter-evidence against this post:

Like you, I believe that monetary policy was the most proximate cause of the 2008 crash. But I think this theory about IOR is way more unlikely than you do, and I would give less than a 1% chance that this data-mined version of an "event study" accurately portrays the information available from markets.

October 6, 2008. Europe was down 5% and S&P Futures were already down 2.5% at 8:15am when the Fed announced IOR. Futures rose on the release before declining again, and were still down 2.5% after trading started, before finishing down 3.8%. Over the weekend, both Fortis and Hypo Bank had to be rescued, and banks in every market were dropping heavily before 8:15.

October 22, 2008. The Fed IOR announcement came at 10am. The S&P was *already down* by 4.1% before the announcement. By 11am it was 1.5% *higher* than its 10AM tick, before closing down 6.1%.

November 5, 2008. The Fed IOR announcement came at 10am. At the time of the announcement the S&P was down 1.5%. In the 30 minutes subsequent to the announcement, it immediately rose to almost flat on the day. It did not start dropping below its pre-announcement level until after noon.

There was never a single Fed IOR announcement that was immediately followed by sharp drop in markets. This seems like it should be extremely persuasive counter-evidence to someone like you, who favors well run event studies the focus on trading just after the announcement before infinite confounding variables enter and take the "event" out of event study.


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COMMENTS (13 to date)
Brian Donohue writes:

But absent IOR, wouldn't the Fed have had to print a lot of money to finance QE, which would have given us the inflation so many expected?

Maybe that would have been a better policy. Is that what you are saying?

Kevin Erdmann writes:

Brian,

Keep in mind that IOR and FFR were both still at 1% until mid December. The Fed had collected nearly a trillion in excess reserves by the time the post ZLB QE programs started.

The counterfactuals of either a sharply dropped FFR in September and/or no IOR could have produced much more monetary accommodation with less balance sheet expansion, although there is no way of knowing how much.

Jerry Brown writes:

Wouldn't movements in the stocks of banks directly affected by the policy be a better indicator than the drops in the overall market? Did bank stocks like Citigroup and Bank of America jump each time IOR was increased?

Scott Sumner writes:

Brian, With or without IOR, the Fed must print money to finance QE, if "printing money" includes producing bank reserves.

I don't think they would have had to print any more money without IOR than with IOR.

Jerry, No, the point of looking at stocks is not to estimate the impact on banks, but rather the impact on aggregate demand, which is better proxied by the overall stock market.

dlr writes:

Like you, I believe that monetary policy was the most proximate cause of the 2008 crash. But I think this theory about IOR is way more unlikely than you do, and I would give less than a 1% chance that this data-mined version of an "event study" accurately portrays the information available from markets.

October 6, 2008. Europe was down 5% and S&P Futures were already down 2.5% at 8:15am when the Fed announced IOR. Futures rose on the release before declining again, and were still down 2.5% after trading started, before finishing down 3.8%. Over the weekend, both Fortis and Hypo Bank had to be rescued, and banks in every market were dropping heavily before 8:15.

October 22, 2008. The Fed IOR announcement came at 10am. The S&P was *already down* by 4.1% before the announcement. By 11am it was 1.5% *higher* than its 10AM tick, before closing down 6.1%.

November 5, 2008. The Fed IOR announcement came at 10am. At the time of the announcement the S&P was down 1.5%. In the 30 minutes subsequent to the announcement, it immediately rose to almost flat on the day. It did not start dropping below its pre-announcement level until after noon.

There was never a single Fed IOR announcement that was immediately followed by sharp drop in markets. This seems like it should be extremely persuasive counter-evidence to someone like you, who favors well run event studies the focus on trading just after the announcement before infinite confounding variables enter and take the "event" out of event study.

Scott Sumner writes:

dlr, Thanks for that information. I agree with you that it makes the linkage much less likely.

At this point one would probably have to argue that the information was so complex that markets took some time to digest it. That's possible, but highly speculative.

One other point---I don't know whether any of this information was leaked. I do recall that IOR required Congressional approval of some sort.

I'll add an update to the post.

dlr writes:

One other point---I don't know whether any of this information was leaked. I do recall that IOR required Congressional approval of some sort.

Unfortunately this aspect will defy honest event study. IOR was scheduled to begin in 2011, and throughout 2008 various Fed members made comments suggesting Congress accelerate that date (e.g. Geithner June 9, 2008: no market reaction). A story came out on 9/18/08 saying Bernanke was requesting acceleration and that was a big up day for the market, but that was probably the 9867th most important story that day. It was left out of the original draft of TARP released over the 9/20 weekend, and the market was down big on Monday. It was then inserted into the next version of the bill, released over the 9/28 weekend, and the market fell of a cliff later that day, but because the bill failed. The market rallied the day after when it became clear the bill would pass. Obviously "leak" evidence is going to be hard to come by, especially given the swarm of competing variables. But if anything, whatever useless evidence exists points in the other direction.

Here's an ancillary question for you. If the Fed Funds rate is above the IOR, why is raising IOR but not raising the FFR contractionary? Ignore a neo-fisherian story where the Fed raises IOR but says it is doing so to increase inflation. If the Fed raises IOR with inflation expectations unchanged, demand for base money increases. This would raise the equilibrium Fed Funds rate given no change in the supply of base money. To prevent the Fed Funds rate from rising, the Fed would presumably have to increase the supply of base money to offset the increase in demand. So why doesn't maintenance of the FFR implicitly counteract the increase in IOR when the FFR is above the IOR? To me the problem wasn't IOR. It was that the Fed was too tight as best indicated by the FFR being above zero from September through December 15.

Kevin Erdmann writes:

Dlr, thanks for the information. On your last point, keep in mind that ior was at or below the target FFR but it was above the effective rate for most of that time.

dlr writes:

On your last point, keep in mind that ior was at or below the target FFR but it was above the effective rate for most of that time.

True, but for a few reasons I don't think matters. First, if we're talking about a very liberal version of market event studies, most of the 2008 drop was over by October 9, the first actual day of IOR. During that time (8/31-10/8) the effective FFR was gyrating, but averaged 1.82%. There was no IOR propping an effective FFR below the target FFR and below IOR (the market finished 2008 roughly flat to the first day of IOR). The second short-lived drop came in Feb 09 when rates were already near zero and effective rates were very close to zero. And of course we know that IOR itself was not an effective floor for FFR; effective rate was regularly well below bot the target and the floor post October 10.

Then there's the more important, semantic issue. To the extent we all (here) agree that the Fed was way too tight in 2008, of course anything that contributed to that tightness can be said to be a proximate causes of the crisis. If one of the main purposes of IOR was to help the Fed achieve its inappropriate target, then there is a sense in which it was a contributing cause. But then so were traders at the NY Fed and Bernanke's internet connection. If you are using a tool to help hit an established target, the target is the more useful problem. And the tool didn't even work well. They almost never hit the target post IOR. So maybe IOR was actually a saving grace because without it they would have found a better tool (selling Maiden Lane assets to dramatically contract reserves until they got their 2%!) that actually worked. Remember, the Fed's problems controlling the FFR actually grew far worse post IOR. So maybe without IOR they would have held the FFR higher, as they did before, despite some volatility.

What really matters in my view are not these mechanical details, but the market's perception of what the Fed was signalling with IOR. My take is that stock market meh reactions to IOR announcements are much more consistent with the idea that the market considered it a technical and largely irrelevant part of a known (mistaken) reaction function. I will leave aside that pretty much every professional investor and journalist I know did not consider IOR as informative about the Fed's reaction function, because I agree that markets are better than surveys. But maybe that will help persuade Scott, because in his book he focuses on a lot on what people seemed to think was important at the time.

Jerry Brown writes:

Is it unreasonable to consider IOR primarily as a means to prop up wounded banks and keep them in business, especially considering the timing of its implementation? I mean it seems to be a contractionary policy begun when the Fed was otherwise trying for expansionary policy.

I mean the Fed was buying up all these financial assets to provide liquidity and depress interest rates and/or increase the money supply. But at the same time, those assets had been providing income for the holders of them, and their sale would represent a loss of ongoing interest income to the sellers, of which I imagine banks were a high percentage of.

So the Fed offers to buy up these assets, at a volume where the demand for which almost definitely increases the price received by the sellers (as in many banks), and then replaces a portion of the future income lost, (but only for those sellers who happen to be banks), with an interest on reserves policy.

Kailer writes:

Really good points, dlr. It made me go digging for the transcripts from this time, and it would seem as you suggest that "the main purposes of IOR was to help the Fed achieve its inappropriate target"

The fed had a conference call on 09/29. They say explicitly that the point of IOR was to sterilize emergency lending and provide a lower bound for the FF rate. At the time the Treasury was bumping up against the debt ceiling and would not be able to sterilize via the "Supplementary Financing Program" (SMF) where the treasury was issuing debt and sitting on the cash to drain reserves.

Some quotes to that effect:

"We can’t keep relying on that program indefinitely, though, because the Treasury’s room under the debt limit ceiling, which was $900 billion as of early last week, is shrinking rapidly because of that program and other ongoing funding commitments. So that’s where the interest on reserves legislation comes in."

"In any case, the interest rate on excess reserves should put a floor—possibly a soft floor, but a floor—under the funds rate and thereby allow the Federal Reserve to conduct monetary policy appropriately while providing liquidity consistent with financial stability"

Kevin Erdmann writes:

Great comments, dlr & Kailer. But, I think the way IOR and the target FFR interacted shows how IOR made things worse. Without IOR, I don't think the Fed would have been willing to sell billions in treasuries in order to hit the target rate. That's why they implemented IOR, so they could keep the rate at 2% without depleting their stock of treasuries.

My shorthand for it is that for the year leading up to Sept. 2008, they had been sterilizing their emergency lending by reducing lending to the government (they sold treasuries and "bought" emergency bank loans). After Sept. 2008, they were running low on treasuries, so they started sterilizing emergency lending by reducing bank lending to private borrowers (they "sold" excess reserves and "bought" emergency bank loans). Before IOR they were sucking cash out of the economy to sterilize the emergency loans. After IOR they were sucking credit out of the economy.

Brian Donohue writes:

Scott, this is either a simple semantic question or I misunderstand what happened completely.

Here's here I think of it:

1. The financial crisis drove trillions of investor dollars into cash.

2. Banks were nervous about their long (credit risky) assets being mismatched with now short liabilities (remember the S&L crisis?)

3. IOR provided an opportunity for banks to stash all this cash. It would earn a pittance, but they are crediting zero, so...

4. All these excess reserves (and not new printed money) were tapped by the Fed to buy up a bunch of banks' long-term assets, expanding the Fed's balance sheet and reducing the banks' asset/liability mismatch.

No need for the Fed to print a bunch of money. Is this story completely wrong?

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