In recent years I have mostly taught Monetary Economics. I spend precisely zero minutes covering IS/LM, and lots of time covering market responses to Fed announcements. Based on some of the comments I received from my last post, I thought it might be interesting to examine one of my favorite Fed announcements, the surprise 1/2 rate cut of January 3, 2001. This was the first rate cut of the 2001 recession, and reduced the fed funds target from 6.5% to 6.0%. Here were some market reactions:
1. The S&P 500 soared by 5.0%
2. T-bill prices rose by 1/32 (yields fell)
3. 28 year TIPS prices fell by 16/32 (yields rose)
4. 28 year T-bond prices plunged by 76/32 (yields rose sharply)
I generally attribute the slight fall in T-bill yields to the liquidity effect, the rise in stock prices and TIPS yields to the income effect, and the sharp rise in T-bond yields to the income and expected inflation effects. IS/LM says easy money lowers rates. I say it is much more complicated than that.
I know I am in the minority, because here’s how the Wall Street Journal (1/4/01) described the market reaction:
Treasury Prices Plummet as Stock Prices Soar on Earlier than Expected Fed Interest Rate Cut
. . . ”Market participants were remembering history: that when the Fed’s on your side, stocks are the place to be,” said Mark McQueen, executive vice president of Sage Advisory Services.
Traders said the selling in bonds also reflected the fact that the market had been anticipating an easing of Fed policy soon and already had rallied strongly on the expectation. When the Fed actually cut rates, people were, in bond market terms, “selling the fact.”
Have you noticed that when reporters don’t have a clue as to what is going on, they attribute it all to market irrationality? No wonder there’s so much hostility to the efficient markets hypothesis. Reporters are taught that easy money leads to lower interest rates. When the markets behave in seemingly irrational ways, the natural reaction is to blame the EMH. Readers of this blog know that easy money often leads to higher long term interest rates, so we don’t have to resort to market irrationality to explain these reactions to Fed announcements.
Some commenters noted that yesterday’s complex bond market reaction reflected changes in the proportions of maturities that the Fed was likely to purchase. Maybe so, but in qualitative terms the reaction really wasn’t much different from January 2001, a policy move associated with virtually no bond purchases. (During normal times the level of excess reserves is tiny and the Fed buys only an infinitesimal amount of bonds when it eases policy.)
Of course most Fed moves are widely expected, and elicit no market reaction. For instance, the Fed did a long series of quarter point increases between 2004 and 2006, which the market took in stride. The biggest reactions occur at key points in the business cycle, when a significant change in policy is contemplated.
The next key policy move occurred in September 2007, when the Fed did its first rate cut of this cycle. Again, the cut was larger than expected (1/2 point), and once again short term rates fell and long term rates rose. Stocks rose a couple percent after the announcement. Asian stocks soared on the news. (Sound familiar?)
In December 2007, the fed funds futures market showed the cut would be either a quarter or a half point. The actual 1/4 point cut caused a severe stock price decline. This time the income effect stretched all the way down to three months, as yields fell from 3 months to 30 years. And remember, these rate cuts were responding to a contractionary surprise, so the IS/LM model says yields should have risen. The stock and bond markets turned out to be prescient. A recession began at exactly that moment, and by January the Fed realized it had blown it. It did two rates cuts totaling 125 basis points within 2 weeks, which validated the earlier T-bill market reaction in December.
This was enough to prop up NGDP for another 6 months. But between July and December 2008 NGDP went into free fall, as the Fed became mesmerized by commodity inflation and failed to respond to abundant signs that NGDP growth was plummeting. Then they became obsessed with the banking crisis. Indeed the great collapse of July-Dec. 2008 was more than half over before the Fed started doing monetary policy, and the first move was not a rate cut but rather the interest on reserves program of October 2008—a highly contractionary move!
Lessons for the Fed? Pay attention to markets that provide information about future NGDP growth, and don’t ever let NGDP expectations going 1, 2, and 3 years out collapse to a level far below trend. And don’t assume that low rates mean easy money.