Monetary Policy and Equity Prices at the Zero Lower Bound

A recent Wall Street Journal article by Jon Hilsenrath raises the question of what will happen to stock and bond prices when the Fed ends its bond-buying program. Tim Duy responds that "Fears of an imminent policy-driven collapse in equity prices are likely greatly over-exaggerated." Duy plots time series of the S&P500 alongside time series of the fed funds rate, noting "it strikes me that previous instances of tighter monetary policy did not trigger immediate widespread declines in equities."

Of course, these previous instances of tighter monetary policy occurred away from the zero lower bound (ZLB), with the target fed funds rate well above zero. Since the end of 2008, with the target fed funds rate at effectively zero, the Fed has attempted to influence interest rates through non-traditional actions such as forward guidance and balance sheet expansion aimed at altering long-term interest rates. If non-traditional expansionary monetary policy has a different effect on equity prices than traditional policy, than non-traditional contractionary monetary policy (i.e. and end to bond-buying) could have a different effect on equity prices than raising the fed funds rate.

How do equity prices react to monetary policy at the ZLB? This is the subject of a Federal Reserve Discussion Series paper by Michael Kiley, "The Response of Equity Prices to Movements in Long-term Interest Rates Associated With Monetary Policy Statements: Before and After the Zero Lower Bound." Kiley studies the impact on equity prices (S&P500) of a monetary policy action that would reduce the 10-year Treasury yield by 100 basis points, both before and during the ZLB era. The key finding is:

Implementation of our identification strategy suggests that, prior to 2009, monetary policy actions that would reduce the 10-year Treasury yield by 100 basis points were associated with a 6- to 9-percent increase in equity prices. In contrast, similar-sized declines in the 10-year Treasury yield associated with monetary policy actions since the end of 2008 have been accompanied by increases in equity prices of 1-½ to 3-percent - a notably smaller association.

The identification strategy is an event-study combined with instrumental variables, focusing on changes in interest rates and equity prices in 30-minute windows around FOMC announcements. The results suggest that non-traditional monetary policy has substantially different--less intense--effects on equity prices than traditional monetary policy. The study only focuses on expansionary actions at the ZLB, by necessity, but if expansionary policy at the ZLB does not cause equity prices to rise as much, then maybe contractionary policy at the ZLB will not cause equity prices to fall as much.
Kiley adds this note:

It is possible that FOMC announcements in the ZLB period have communicated more information about the economic outlook than about the policy stance: If FOMC communications provided previously unappreciated information about the outlook, then it is possible that such information would attenuate the response of equity prices to a policy announcement (because, for example, announcements communicating an easing in policy also communicated a worse economic outlook, with the former factor boosting equity prices and the latter factor depressing equity prices.)

Correspondingly, when the FOMC announces the end of its bond-buying program, that could communicate both a tightening in policy and a better economic outlook. If the announcement makes market participants realize that the economic outlook is better than they thought, that would help boost equity prices. The big question is how much tightening it will indicate. Scaling back asset purchases is tightening in and of itself, but probably not enough to cause a collapse in equity prices. But if the announcement also makes market participants expect a series of interest rate hikes to soon follow, then the depressing effect on equity prices will be much greater. Tim Duy adds in another post that "A challenge for the Fed is that asset purchases are at least in part a communications device that signals commitment to a given policy path. Thus, the Federal Reserve will need to take care to avoid the impression of imminent rate hikes as they scale back asset purchases."

Safe Assets and Financial Crises

Mark Thoma has shared a link to a new working paper by Gary Gorton and Guillermo Ordoñez called "The Supply and Demand for Safe Assets." The paper brings to mind a once-confidential document written by economists in the Clinton Administration called "Life After Debt" which was recently made public by the team at NPR's Planet Money. The report notes:

In the year 2000, the U.S. Treasury began actively buying back the public debt; we should all appreciate the tremendous achievement this represents for the Nation as a whole... We must realize however, that a sharp reduction in Federal debt and the possible accumulation of a Federal asset raises at least three important issues. First, investors looking for an asset free of credit risk can no longer count on an abundant supply of U.S. Treasury securities, and Treasury securities may no longer provide a reliable benchmark for other interest rates. Second, the Federal Reserve may have to change the mechanisms by which it conducts monetary policy. Third, continued surpluses after the public debt has been paid off will require the Federal. government to acquire assets; either directly or though the Social Security Trust Fund. This raises issues about what kinds of assets might be acquired, and the best way to manage this task.”

Gorton and Ordoñez's paper is relevant to the first of these issues. The Clinton Administration report elaborates on this issue, saying:

US Treasuries are considered free of default risk by investors the world over...The remarkable liquidity of Treasuries is also a result of the full faith and credit of the United States Government.  Holding a liquid asset is valuable because it affords an assurance of convertibility, and thus fast and easy access to capital.  Private investors, the Federal Reserve and many foreign central banks have used Treasuries to fulfill their need for a riskless, performing asset with liquidity second only to currency.

Gorton and Ordoñez note that the share of safe assets in the U.S. economy has remained constant since 1952. However, the composition of these safe assets varies. Safe assets consist of both U.S. Treasuries and privately-produced substitutes, so when the supply of Treasuries declines, the share of private subsitutes rises. What can be a private substitute for Treasuries? Typically, asset-backed securities. Collateral is key.

In Gorton and Ordoñez's model, for simplicity there is just one type of collateral: land. Land can be either "high quality" or "low quality." While the average land quality is known, there is no public information about which land is high quality and which is not. Borrowers can use their land as collateral to finance investment projects, and lenders don't know the land quality unless they pay some cost to find out. This is a type of financial friction: it is inefficient for the economy as a whole if lenders pay a cost to learn about collateral quality, because that cost does not result in any production.

In the model, there are normal times and crisis times. In normal times, the average land quality is high enough that lenders are better off NOT paying to check the quality of the land. The inefficiency from the financial friction is avoided. However, there can be shocks to the average quality of land. Land quality may get low enough that  lenders need to check the land quality before they accept it as collateral, resulting in economic ineffiiency and a financial crisis. This is where Treasuries come in. Government bonds can also be used as collateral, and they don't suffer losses in value like land does. In short:

Since bonds can be effectively used as collateral, a larger fraction of bonds buffers the economy from potential shocks to the expected value of land that may reduce its role as collateral, inducing a lower probability that such shock translates into a financial crisis. This is consistent with the empirical findings of Krishnamurthy and Vissing-Jorgensen (2012a); an increase in Treasury debt decreases the probability of a financial crisis. In our setting this is because bonds can be used as superior substitutes for private collateral – they are independent of shocks to land.

Of course, they are not just advocating for the government to run up a huge debt.The model also includes taxes, and they make the important additional note:

But, if taxes to repay bonds are distortionary, it may be optimal for the government to issue debt in times of crisis, but not in normal times. 

"Land," remember, is a modeling simplification, and really encompasses all types of private collateral. Before the recent financial crisis, there was a surge in the creation of "safe" private assets using "pools" of collateral including loans, bonds, and mortgages. Josh Koval and Erik Stafford explain:

The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create "safe" assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised.

For a time, the AAA-rated top tranches of these manufactured assets were considered really safe, and it was like the "normal times" in the model when lenders trust that on average, collateral quality is good enough that they don't need to pay the extra cost to check on it. But then it became apparent that the average quality was much lower, and these assets became less effective collateral, and the financial crisis began. There are at least some claims that the Clinton surplus kicked off the rise in mortgage-backed securities issuance. (I included two graphs below, made using data from FRED, in case you want to evaluate the claims for yourself.) If you decide to read "The Supply and Demand for Safe Assets," please do also look at Krishnamurthy and Vissing-Jorgensen's empirical counterpart. Or, for something lighter, listen to Planet Money's episode "What If We Paid Off The Debt? The Secret Government Report."