I’ve frequently argued that the interest on reserve policy was a huge mistake, comparable to the 1936-37 decision to double reserve requirements in the midst of the Great Depression. I pointed out that both policies sharply increased the demand for base money, and the implementation of IOR was associated with a big stock market crash during the first 10 days of October, 2008. I don’t know exactly when the stock market understood what was going on, but I read that the decision was made on October 3rd, announced on the 6th, and implemented on the 8th. Whatever the exact dates, it’s clear that the story became understood at some point during the famous crash.
The title of the post refers to frequent commenter (and blogger) 123, who knows more about the IOR program than I do, and disagrees with my view that it was contractionary. Indeed he argues it was beneficial. I’m wondering how he will react to this Louis Woodhill piece from RealClearPolitics:
The available data indicates that it was the Fed’s IOR program, not the collapse of Lehman Brothers on September 15, 2008, that crashed the real economy and sent unemployment skyrocketing. Because the two events were only three weeks apart, many people believe that it was the Lehman bankruptcy that precipitated the worst economic downturn since the Great Depression. However, the market data from that period suggests strongly that the real cause was IOR.
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’ve always thought the timing of the implementation of IOR was an interesting coincidence, but hardly definitive. But for some reason I never got around to closely investigating the program in detail. I had no idea that the two subsequent IOR rate increases were also associated with mini-crashes. Again, the evidence is hardly definitive. But crashes this size are quite rare. To have all three contractionary IOR decisions (and the only contractionary IOR decisions in all of American history!) each be associated with a once-in-a-blue-moon market plunge, is certainly suspicious. I’m surprised others haven’t made a big deal of this pattern—people have spun elaborate economic theories based on much flimsier empirical evidence. And remember, economic theory predicts the decision should have been contractionary.
Over to you, 123.
PS. There’s an easy way to test this theory. If Bernanke finds QE2 doesn’t produce the effects he’s looking for, he should try lowering the IOR to 0.15%. No need to worry about those annoying regional Fed presidents; the Board determines the IOR. And you won’t have Sarah Palin looking over your shoulder—I can’t imagine the Tea Party would get up in arms over a Fed decision to slightly reduce the Fed’s subsidy to big banks.
Here’s a prediction–the Dow rises 10 points for each 1 basis point reduction in the IOR.
Update 11/12/10: 123 has responded on his (or her?) blog. As I indicated, he knows more about this that I do. Part of our dispute has been over the “other things equal” assumption. I look at the IOR issue holding the size of the base constant, he tends to assume that the increase in the base was facilitated by having the IOR program. He also discusses the problem of increased uncertainty over future fed funds rates, something I know little about. I do have one question, however. 123 says:
As October 2008 FOMC minutes put it, “In the overnight federal funds market, financial institutions became more selective about the counterparties with whom they were willing to trade.”
Is the implication that IOR solved the counterparty risk problem? If so, how? And why is the uncertainty about fed funds rates a big problem, when the level of rates was low thoughout this period, and extremely low if you recall that these are overnight loans. How much risk did ffr instability actually produce?
PS. I love that George Bush quotation at the end of his post.