The author Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
During the past few months, the U.S. stock market has surged as the the Federal Reserve bought hundreds of billions dollars of Treasury bills to add reserves to the banking system and calm the repo market. Are the two connected? Or is the stock market going up for other reasons? The answer is important because the Fed’s large T-bill purchases will end soon. If the central bank’s balance-sheet expansion is truly lifting stocks, then the market is vulnerable when these purchases cease.
I am skeptical that the Fed’s balance-sheet expansion is having a major effect on U.S. stock prices. First, of course, correlation isn’t the same as causation. Just because two things are moving together doesn’t mean that one causes the other. Second, and more importantly, the notion that the Fed’s actions are fueling a stock market bubble isn’t supported by how the Fed’s T-bill purchases are affecting short-term interest rates or how the Fed’s actions are increasing liquidity in the financial system. Third, there is a more obvious explanation behind the stock market’s rise: the prospect of a sustained economic expansion and a Fed that is likely to stay on the sidelines and not raise its federal funds rate target in 2020.
Turning first to the impact of the Fed’s purchases on short-term interest rates — it has been trivial. At the beginning of September, before the upward pressure on repo rates and the Fed’s decision to buy $60 billion of T-bills per month, the spread between the effective fed funds rate and the rate that the Fed pays on reserve balances was about three basis points, or three-hundredths of a percentage point. Today, that spread has fallen to roughly zero. When the supply of bank reserves increases substantially, this puts modest downward pressure on the fed funds rate because more of the trading activity occurs between banks and the government-sponsored enterprises that cannot earn interest on their cash balances at the Fed, rather than trading among banks.
Similarly, the Fed’s T-bill purchases have had only a small impact on the level of T-bill rates relative to the fed funds rate and the interest rate that the Fed pays on reserves. This is a bit harder to sort out because the longer maturity of T-bills means that expectations of Fed rate cuts affect T-bill rates but not overnight rates. But even here it is hard to discern much impact from the Fed’s asset purchases. At the beginning of November, after the Fed’s last rate cut, the spread between the four-week T-bill and the effective fed funds rate was three basis points. That spread now is close to zero.
So it isn’t rates. But couldn’t it be that the rise in bank reserves is increasing liquidity, fueling the equity market? The problem with this argument is that when the Fed buys T-bills and increases the amount of reserves in the banking system, that liquidity can’t go elsewhere. It can move from bank to bank as households and businesses shift where they hold their bank balances. The only exception is if bank customers decide to increase their holdings of currency. But if they do that, that reduces the amount of excess reserves in the banking system.
The Fed’s T-bill purchases substitute a bank reserve (essentially equivalent to a one-day T-bill) for a slightly longer risk-free asset (a T-bill) that the Fed now holds in its portfolio. But that’s it. There are no funds created to purchase equities.
In contrast, the quantitative easing by the Fed from 2009 to 2013 removed long-duration, fixed-income assets from the market. This pushed down long-term bond yields significantly and made equities relatively more attractive.
There are much better explanations for the recent rise in the U.S. stock market than the Fed’s T-bill purchases. I would put three developments front and center:
The Fed cut its fed funds rate target by 75 basis points in 2019 to a range of 1.5% to 1.75%. Monetary policy is more accommodative now than a year ago. Longer-dated yields are also lower as a consequence. The Fed has signaled that it is unlikely to raise rates until inflation climbs meaningfully above the central bank’s 2% inflation target. As a result, both the Fed and market participants believe that monetary policy will remain on hold in 2020. The risk of a U.S. economic slowdown seems to have subsided. Most notable is the abatement of trade tensions with China and the expectation that in an election year, they will remain subdued this year.
The Fed’s expansion of its balance sheet and the increase in bank reserves have stabilized U.S. money markets. As a result, the Fed is likely to gradually taper its repo-market interventions and significantly slow its T-bill purchases after the April tax season. The end of this aggressive provision of bank reserves, however, is unlikely to create major problems for the U.S. equity market. Instead, what will matter is the economic outlook, the risk of a U.S. economic downturn, whether inflation rises and whether the Fed will stay accommodative.