Behind the Scenes the Fed is Applying the Brakes

Louis Woodhill has a interesting critique of QE2 over on RealClearMarkets, basically arguing that while the Fed is pouring on the money with one foot they are hitting the brakes with the other foot with its “interest on reserve” program:

on October 6, 2008, the Fed hit the monetary brakes by announcing that it would start paying interest on reserves (IOR) for the first time in its 95-year history.

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.

The stock market decline was accompanied by a plunge in employment. Total employment (BLS household survey) had fallen by 1.2 million jobs over the six months April 2008 – September 2008. During the six months after the Fed announced IOR (October 2008 – March 2009) total employment fell by 4.2 million jobs.

Woodhill goes on to argue that the “payment of IOR at an “above market” interest rate (which has been the case for the past two years) short-circuits” recovery and “creates a ‘roach motel’ for money – the dollars go in and they don’t come out.”

See the whole piece here.