The Federal Reserve and the stock market often appear to be moving together. Just who is moving who? Some new research suggests an answer.
First, let’s define the issue. Between the summer of 1998 and the end of 2008 — spanning the period from the Russian debt default and collapse of hedge fund Long-Term Capital Management to the global financial crisis (GFC)— the Fed’s behavior was widely described with the words “Greenspan Put.” The notion among traders was that the US central bank’s interest rate moves were driven by the stock market. If the S&P 500 was falling, it would feel the need to cut. If the market rose, the Fed would after a suitable interval start raising rates.
Since the GFC, things have been different. With the fed funds effectively at zero for most of the post-crisis decade, the Fed’s balance sheet, and successive doses of quantitative easing, or QE, asset purchases, have taken over as the chief monetary policy tool. That has led to another crude and effective chart, which maps the S&P against the size of the Fed’s balance sheet since the beginning of 2009. The Fed made a heroic attempt to reduce its assets for a few years, but with the second crisis the apparent relationship is restored. The S&P rises and falls in line with the balance sheet. If the market declines, the Fed responds with a big increase.
Most everyone who knows anything about markets knows that the Fed’s actions have a huge impact, and that for the last 20 years they appear to have been more influenced by the stock market than before. But correlation doesn’t imply causation. What can we say about exactly how much stocks affect the Fed, and how much the Fed affects stocks?
Talis J. Putnins of Sydney’s University of Technology has attempted to quantify it in a new paper, provocatively entitled From Free Markets to Fed Markets. It can be downloaded here. He looked at the strength of the correlation between changes in the Fed balance sheet and changes in the the S&P’s level for each week from two months before to two months after the change in the balance sheet.
There is a negative correlation between what the S&P did a month ago and moves in the Fed’s balance sheet. In other words, if the S&P falls we should expect the balance sheet to be increased about a month later. Once the Fed has made its change, we should expect the two to move in the same direction for the next month — a rising balance sheet raises the S&P, a shrinking balance sheet brings it down. The lag is clear; it takes about a month for a weak stock market to prod the Fed into a response, and once that response has been made the effect is felt in full a month later.
There was also — and this should surprise nobody — a marked asymmetry to the Fed’s actions. It responds to falls in the market with alacrity. It doesn’t seem to feel any great macro-prudential need to prick bubbles by comparison, and so the tendency to respond to a rise in stocks with a shrinking of the balance sheet, as seen at the end of Janet Yellen’s tenure and the beginning of Jerome Powell’s, was much weaker. In late 1996, less than two years before the “Put” era began with LTCM, Alan Greenspan was plainly worried about the possibility of asset bubbles, and uttered his famous warning of “irrational exuberance” (following through with a rise in rates that induced a minor stock market correction). Now, the idea of raising rates to curb share prices appears so outlandish to Powell that he said in June “we would never do this.”
When Putnins tried to quantify the “put” relationship between increases in the balance sheet intended to bail out the market and their impact on stocks, he yielded the following:
A 10% fall in stock markets is estimated to result in a cumulative balance sheet expansion of around 6.7%, while a 10% expansion of the Fed’s balance sheet is estimated to result in a positive 7.4% impact on cumulative stock market returns over the following five to eight weeks.
When it comes to explaining the amazing stocks rally, which continues as the world is ravaged by a miserable economy and a pandemic that refuses to be extinguished, Putnins was able to confirm that the Fed has had a lot to do with it (although not everything). On his assumptions, between 10 and 13 percentage points of the S&P’s gain since the Fed intervened in March can be explained by that Fed intervention. There is room to explore how this happens — whether it is just an effect on confidence, or whether the fall in bond yields prompts investors into buying stocks, for example — but the common sense result is confirmed. The Fed didn’t used to behave this way, but it does now, and the result is that stock prices, which tend to rise over time anyway, have an asymmetrical pressure on them to go up, rather than down.
Bloomberg
