More Evidence that Monetary Policy was Important in late 2008.

(A more concise version of this post with fewer examples is available here)

Here I present evidence that markets responded sharply to monetary policy during the late 2008 financial crisis.

Perhaps most notably, I find that markets tended to cheer traditional monetary policy (policy aimed at increasing aggregate demand) and snub fed policies aimed at fixing credit markets. This certainly flies in the face of the mainstream explanation for the recession.

The Data

As a general rule, during late 2008, increases in stock prices were correlated with increases in nominal yields, inflation expectations, and expected future Fed funds rates. This isn't surprising. If the correlation  between expected future fed funds rates and other asset prices breaks down however, it should give some kind of an idea of impact of monetary policy.

Note: This means that it is possible that monetary policy was still the cause of certain declines in equity prices and that although fed funds futures fell they didn't fall enough. The data I use only makes use of days in which the markets moved in "opposite" directions and so my case may actually be stronger than it looks.

October 6, 2008

The S&P, nominal rates, and inflation expectations all tumbled while the dollar rose 1%.  Basically all of the 4% decline for the day took place immediately after the market opened. The likely cause?

October 6 was the day the Fed first announced it would pay interest on excess reserves (released at 8:15 am)

Scott Sumner has long argued this policy greatly sharply tightened monetary policy during late 2008. So even though the expected FF rate fell (although note that 3 month treasury yields rose slightly), perceived policy was much tighter and markets responded.

(See October 7 for data)

October 7, 2008

A day later on October 7, Bernanke announced a plan to loosen credit markets. Stocks initally rose slightly, but went south during the Bernanke speech, and further declined when a hawkish Fed Minutes report ("The minutes showed the bankers were equally worried about growth and inflation at the Sept. 16 meeting") was released.

It seems likely these events were what they were responding to. Stocks fell dramatically, nominal rates actually rose (but especially at the short end of the curve) along with expected fed funds rates, while inflation expectations plummeted.

October 13, 2008

October 13 was the biggest rally of the period (and the fifth biggest rally in the DOW EVER) and, "The surge came as governments and central banks around the world mounted an aggressive, coordinated campaign to unlock the global flow of credit, an effort that investors said they had been waiting for."

October 15th, 2008 

And the biggest losing day of the period? Two days later on October 15th. Guess what sent the market tumbling.

"Selling picked up momentum in the afternoon as the Federal Reserve’s chairman, Ben S. Bernanke, cautioned Americans that the bailout would not swiftly lift the economy and that continued weakness was certain."

The selloff seems like exactly the type of reaction one might expect if markets thought the Fed would do what was necessary to prevent NGDP from falling the 13th, only to realize it was hopelessly focused on the financial crisis (and not aggregate demand) two days later. And why would a Fed Chairman ever say continued weakness was certain? If that was the case shouldn't they ease policy?

October 20, 2008

The 4.7% rise in the S&P during October 20 serves as more proof that the U.S. faced an aggregate demand problem more than a financial one. Stocks rallied as Bernanke endorsed a second fiscal stimulus plan. Now admittedly, markets may have been reacting simply to a bigger fiscal stimulus with a better chance of passing, but it could also be argued that Bernanke's support reassured markets the Fed wouldn't offset the fiscal stimulus.

My guess is it was a mix of both, but still the rally that day certainly serves as more evidence that the primary issue in late 2008 was low AD.

October 22, 2008.

On this day the Fed announced it would raise the amount of interest paid on excess reserves.

Again, even though 3 month treasuries and fed fund futures signaled slightly lower future fed funds rates, overall policy was likely seen as tighter. Even though this policy helped the Fed increase its balance sheet they were essentially trading AD enhancing policies for ones which helped financial markets. Equities, nominal rates and inflation expectations all fell sharply while the dollar rose sharply.

October 28, 2008

One of the strongest pieces of evidence that monetary policy mattered a great deal during late 2008.

Equities, nominal yields and inflation expectations all rallied sharply while 3 month treasury yields and FF futures fell. Had this been some non-monetary shock, FF futures and 3 month treasury yields should have risen.

I expected that there may have been some bailout or financial news that pushed up markets, but when I looked there was nothing of the sort. News that day noted that..."Stock analysts struggled to make sense of the gains"  but also acknowledged that the Fed may be partly behind the rally.

October 30, 2008
 A smaller, but similar market reaction as October 28th.

This article noted expectations had increased for the Bank of Japan, the ECB and the Bank of England to ease policy as well.

November 4, 2008

Again all the signs of easier expected monetary policy boosting AD expectations show up once again. Equities, oil and inflation expectations rose while fed fund futures, 3 month treasury yields and the dollar fell. CNN attributed the rally to the election, but this was the day of the election not the day after (no results were in yet) so that explanation makes no sense to me.

November 5, 2008
Again a day when the Fed raised the interest paid on reserves. A bad ISM services report also came out that day, but markets didn't seem to clearly be reacting to that. Note also that fed funds futures actually increased slightly despite a sharp fall in stocks, nominal yields and oil prices (down 8% according to the NYT article).




November 7, 2008
Another rally with seemingly no explanation, except for easier money.

A trader remarked “The lesson people have to learn is they can no longer look for rational reasons for why short-term moves are happening,”

Hmm. Maybe, but I like my explanation better.

December 1, 2008
Another really notable day when stocks, nominal yields and oil fell dramatically while 3 month treasury yields, fed fund futures and the dollar rose.

Again there was no clear news event that day that would cause such a collapse.

(Something bizarre seems to have been going on with TIPS yields data that day but 5 year inflation swaps show a more plausible decline in 5 year inflation expectations)

December 16, 2008

The day of the all important Fed announcement. although it wasn't seen as all important (by the media at least) at the time.

The Fed surprised markets by cutting more than expected (to 0-0.25%), downplaying inflation risks, and hinting at possible quantitative easing. Stocks and inflation expectations rose significantly and the dollar fell. Nominal rates fell as well (probably in response to potential QE purchases) but overall the response was obviously very positive.

Conclusion : 

Obviously if you are only looking at days in which monetary policy and markets moved it opposite directions it will, by definition, look like monetary policy matters a lot... but the magnitudes are what are impressive. The two biggest increases, as well as the two biggest declines in equity prices during the period seem to be strongly correlated with changes in expected monetary policy.

I think this data strongly supports the belief that monetary policy mattered a great deal in late 2008. It also supports the idea that insufficient AD was a bigger problem than the financial crisis (which were indeed being fed by AD problems). Markets could of course always be wrong, but from today's standpoint (deflation and high unemployment in despite a relatively normal financial sector) they seem to have been quite correct.

(Data for the S&P was acquired form Google Finance, Fed Fund Futures data was acquired from the Cleveland Fed, Oil data was recovered from daily CNN Market report articles, and all other data was downloaded from FRED)

Did Bernanke send markets (further) tumbling on December 1st?

If market expectations of fed policy changed dramatically on the days previously mentioned, what may have caused those changes?

I previously noted that December 1st an odd day in that expected future fed funds rates and 3 month treasury yields increased despite sharply falling stock prices and longer term bond yields.

I consider this Bernanke speech to be a prime candidate for what pushed markets and monetary expectations in "opposite" directions.

Some notable quotes:
"Amid the bad news, there have been some positives. The pronounced declines in the prices for crude oil and other commodities have helped to reverse what had been a significant drag on household purchasing power through much of the year."

Oh no. Anyone who understands supply and demand knows this is nonsense. The reason oil and commodity prices had fallen was because NGDP was plummeting. (Bernanke knows this, and markets know he knows this, but I'll point out why I think it's significant later)

"At the same time, the increase in economic slack and the declines in commodity prices and import prices have alleviated upward pressures on consumer prices. Moreover, inflation expectations appear to have eased slightly. These developments should bring inflation down to levels consistent with price stability."

Eased slightly? They had fallen off a cliff! By this point they were 0.34% over the next 10 years according to the TIPs spread and were slightly negative according to 5 year inflation swaps. And even looking backward, headline inflation was 1.07% at that point.

The theme of this speech seems to be "Employment, real GDP and every other economic measurement is looking awful, but there is good news... Inflation and commodity prices are really low!" This is exactly the speech markets shouldn't want to and didn't want to hear. Although I doubt Bernanke really believed what he said here, I think this gives you terrific idea of the hawkish stance of the Fed as a whole at that point. If nothing else, this speech showed that Bernanke(who I'm assuming was more dovish than other Fed members) was not going to fight hawkish members of the fed to ease policy.

Anyone looking back at this speech today knows it was a complete disaster. The Fed obviously should have been fighting deflation and looking and falling prices with worry... So how did markets react?

In a perfect world we could compare intra-day fed funds futures to this chart, but I don't believe they are available anywhere. The speech took place on 1:45 PM, so markets falling at about 3 pm seems reasonable(especially since the markets seems to react a bit slower to speeches than to rate changes). The Dow fell 3% seemingly directly in response to this speech (and remember, no other big news events occured that day).

Perhaps more damning is this CNN article titled "Bernanke: Look for programs not rate cuts". If CNN could pick it up surely markets could have and did. This may actually be the strongest evidence that the market was looking for traditional monetary policy over fixes for the financial sector.

Evidence that monetary policy was important in late '08.

As a general rule, during late 2008 increases in stock prices were correlated with increases in nominal yields, inflation expectations, and expected future Fed funds rates. This isn't surprising. If the correlation  between expected future fed funds rates and other asset prices breaks down however, it should give some kind of an idea of impact of monetary policy.

There are two very notable days which I believe show the strength of monetary policy during the period. The first (October 28) was positive and the second (December 1) was negative.

1) October 28, 2008. The S&P rallied 10.79%, the 30 year treasury yields rose 7 basis points, 10 year Treasury yields rose 4 basis points, AAA bond yields rose 10 basis points and BAA rated bond yields rose 9 basis points, and the 10 Year TIPs spread increased from .77 to .83. Meanwhile the expected FF rate in December fell from .860 to .825 and the three month treasury yield fell from 0.84 to 0.77. If this were related to some non-monetary shock, FF futures and treasury yields should have risen, not fallen.

I expected that there may have been some bailout or financial news that pushed up markets, but when I looked there was nothing of the sort. News that day noted that... "Stock analysts struggled to make sense of the gains"  but also acknowledged that the Fed may be partly behind the rally.

2) December 1, 2008. S&P down 8.9%, 30 year yield fell 23 basis points, 10 year yield fell 22 basis points, AAA yields fell 25 basis points, BAA yields fell 19 basis points and the TIPS spread rose by 1 basis point. Meanwhile, the December expected FF rate rose from 0.417-0.433, 3 month treasury yield rose 6 basis points and the dollar rose by 0.23%.

Again there was no clear news event that day that would cause such a collapse.

Obviously if you are only looking at days in which monetary policy and markets moved it opposite directions it will, by definition, look like monetary policy matters a lot... but the magnitudes are what are impressive. Those days represent the second biggest gain and second biggest loss in equity prices during the entire crisis!

And what of the biggest gain and biggest loss days? They also seem to be correlated with changes in the perceived stance of monetary policy.

October 13th was the biggest rally of the period (and the fifth biggest rally in the DOW EVER) and, "The surge came as governments and central banks around the world mounted an aggressive, coordinated campaign to unlock the global flow of credit, an effort that investors said they had been waiting for."

And the biggest losing day of the period? Two days later on October 15th. Guess what sent the market tumbling.

"Selling picked up momentum in the afternoon as the Federal Reserve’s chairman, Ben S. Bernanke, cautioned Americans that the bailout would not swiftly lift the economy and that continued weakness was certain."

The selloff seems like exactly the type of reaction one might expect if markets thought the Fed would do what was necessary to prevent NGDP from falling the 13th, only to realize it was hopelessly focused on the financial crisis (and not aggregate demand) two days later. And why would a Fed Chairman ever say continued weakness was certain? If that was the case shouldn't they ease policy?

(Data for the S&P was acquired form Google Finance, Fed Fund Futures data was acquired from the Cleveland Fed, and all other data was downloaded from FRED)