The role of the Federal Reserve System for the stability of
the US and world financial markets
Name: Alena Kukol
University: University of Amsterdam
Faculty: Faculty of Economics and Business Date: 26/06/2018
Supervisor: Daniel Dimitrov Bachelor: Economics and Finance Number of EC: 12
Statement of Originality
This document is written by Student [Alena Kukol] who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Abstract
The role of the United States in the world financial system is determined by indisputable leadership due to the scale and the level of the economy and the scientific and technical potential. The dominating position of the dollar as the basis of the world monetary system was established after the Second World War. The US national currency clearly prevails in the trade settlements, financial markets, and in the centralized foreign exchange reserves all over the world. The Federal Reserve System is a central bank of the most powerful country. Hence, the goal of the paper is to analyse the effects of the Fed’s measures on the US and the world’s financial market stability before (01/01/2005-14/09/2008), during (15/09/2008-31/01/2010), and after the crisis (01/02/2010-01/01/2017). The results are found through the quantile regression analyses using longitudinal data with index prices. According to the results of the regression, international and US markets were unstable for both markets during the first and the second studied periods. The third period was stable for the international market and unstable for the US financial market. In conclusion, the Fed has a big influence on the financial markets, and the real sector of the economy of the USA and all other countries.
Content:
1. Introduction and research question 2. Literature review
2.1 History of FRS
2.2 Importance of US on the world market
2.3 Critical literature review: overview of other models 2.4 Analysis of Fed actions during Financial Crisis 2007/2008 3. Methodology and Empirical analysis
3.1 Empirical model 3.2 Hypothesis
3.3 Output and analysis 4. Discussion of results 5. Conclusion
1. Introduction
The research question of the study is the following: the politics of the FRS and its influence on the stability of the US and world financial markets using a quantile model with daily continuously compounded index returns of stocks for the period 2005-2017 (Baur & Schylze, 2009).
The goal of the paper is to explore the effect of Fed’s measures on the financial market stability. Longitudinal data with quantile regression analysis using stock prices as input is used in this empirical research. However, research is hampered by the fact that there is no general notion for financial stability. According to the European Central Bank (ECB) (2017), “Financial stability is a state whereby the build-up of systemic risk is prevented”. Padoa-Schioppa (2003) said: “Financial stability is a condition whereby the financial system is able to withstand shocks without giving way to cumulative processes, which impair the allocation of savings and investments opportunities and the processing of payments in the economy”.
The importance of the paper is defined by the economic superiority of the USA over the rest of the countries predetermined its influential positions in the world’s financial system and the key position of the dollar for the world’s monetary system. US dollar or the Federal Reserve note is issued by the Federal Reserve System (FRS) which becomes the most powerful organization. So, it is important to understand how the FRS can influence the financial market.
In the second section, the history of the FRS is explored to have a better overview of the Fed, its structure and objectives; highlighted the importance of US on the world market to have an understanding of the importance of the topic and policies of FRS that will influence other countries through diverse channels. Different macroeconomics models are presented for the study of the financial market stability due to the fact there is no common definition of “financial stability” term. Also, the analysis of the FRS actions during the crisis 2007-2008 is given. Conventional as well as unconventional policies were used during the period. Therefore, it is a good time to examine the influence of the Fed on the stability of the markets. In the third section, the methodology and empirical analysis of the paper is described. Next part includes the analysis and matching of the Fed’s politics and the results of stability of the financial markets. Finally, the work is going to end up in a conclusion.
2. Literature review
2.1 History of FRS
When the United States was a British colony, American monetary circulation was serviced by British pounds. After the War of Independence, Americans decided to establish their own currency (Starikov, 2011). In 1785, the US congress declared the dollar as the national currency.
In 1790 (three years after the signing of the American Constitution) Alexander Hamilton, the first secretary of the Treasury, proposed for consideration of the congress a bill to create a new private central bank. Later it was approved by the congress in 1791 (Van Fenstermaker & Filer, 1986). It received a license for a period of twenty years. It headquartered in Philadelphia, and had a complete monopoly on the issuance of the American currency (Starikov, 2011). 80% of its shares were to be owned by private investors, and 20% were transferred to the government (Starikov, 2011). It took time before the typewriter of the money could be used at full capacity. At first, people had to get used to the paper notes. Secondly, all other types of exchange had to stop their existence (Starikov, 2011).
In 1811, the 20-year term license of the First Bank expired and it was not renewed by the congress because freedom-loving Americans were extremely cautious about the financial sphere. A second US bank was created. It was an exact copy of the First one: the second US bank was private, with a license for the same twenty years (Van Fenstermaker & Filer, 1986).
After the license of the Second Bank of the United States expired, it stopped its existence, and the Free Banking Era began. Some banks received a permission from the state authorities to carry out banking activities and banks that did not get a permission were "free banks". They issued their banknotes to be redeemed in gold or other valuables (Rockoff, 1974). Paper money was issued by states, cities, counties, private banks, railways, shops, individuals and religious organizations. The government was not in a position to control the process. In the 50-60s of the XIX century in the USA there were from five to ten thousand of different types of banknotes issued by someone. Thick directories were issued to put more clarity in the circulating money. They gave information about which banknotes remained in circulation, what should be accepted at a discount, and
which lost their solvency (Pryagnikova, 2012). At the same time, the number of fake money had also increased, and centralized monetary circulation was destroyed(Starikov, 2011).
In order for the American currency to become an instrument of expansion, it had to be unified. In 1862, a law "Legal Tender Act" was adopted. The first paper money was issued by typewriters of the state and they became the first state money of the US after a long period of time of private money circulation (Starikov, 2011). The sum of these banknotes was subject to the restriction established by the congress. The statutory restriction of banknotes allowed for circulation was $ 346 million (Starikov, 2011).
In 1913 the Federal Reserve System was established as the central bank of the US by the Federal Reserve Act (Board of Governors of the Federal Reserve System, 2017). The world “Federal” emphasized the law that is applicable for the whole country. “Reserve” meant the role of institution as a reserve holder and supplier (Timberlake, 2008). The words “Central Bank” were not used in the name of the institution for the purpose. The term was very unpopular among the Democratic party that had a majority in congress and the White House (Timberlake, 2008).
The main governing body of the Fed is the Governing Council. It composed of seven members appointed by the President of the United States with the approval of the legislature (Chuvahina, 2012). 12 regional branches of the FRS are subordinated to the Board of Governors. They are called the Federal Reserve Banks. The Federal Reserve Bank of New York is the most important one (Chuvahina, 2012). It is responsible for international financial transactions and operations on the open market and has a permanent voice in the Open Market Committee (FOMC), which takes care of the monetary policy. The decisions of the Federal Open Market Committee are aimed at stimulating the economic growth while maintaining the stability of prices and monetary circulation (Chuvahina, 2012).
In accordance with the US law, the Federal Reserve System has four main objectives (Board of Governors' Publications Committee, 2005):
1. Conducting the national monetary and credit policy by influencing the monetary and credit indicators of the economy in order to ensure full employment and maintain the stability of the price level in the country.
2. Supervision and regulation of the activities of banking institutions to ensure the safety of the national banking and financial systems, as well as the protection of consumer credit rights.
3. Maintaining the stability of the financial system and deterring the financial risk that may arise in financial markets.
4. Provision of certain financial services to the US government, society, financial institutions, and foreign state institutions. It includes the main role in the management of national payment systems.
2.2 Importance of US on the world market
The USA is the leader of the world economy. The country is much ahead of any other country by the level of its development (Kozik, 2003). With an increasing globalization of the international economy, the US business activity level is an indicator for the economy in the world. Economic processes in the United States of America are one of the main generators of shifts in the world’s economy (Kozik, 2003).
The US dominates world trade, export of borrowed capital, direct and portfolio foreign investments. Today this predominance is realized mainly in the scale of economic potential and the dynamism of its development, scientific and technological progress, foreign investment and the impact on the world financial market (Kozik, 2003).
Over the past decade, the role of the United States in the global economy has radically changed, due to the movement of foreign direct investments. They are carried out mainly by transnational corporations (TNCs). International production is actively formed and it strongly unites the US economy with the economies of other countries (Kozik, 2003). The international production network, created by foreign direct investment, is usually called the second economy. The second economy of the US occupies a special place in the world system. In terms of its production, scientific, technical and financial potential (Kozik, 2003).
Intensive interaction of foreign enterprises of American TNCs with US economic structures is manifested in the increasingly close production cooperation of foreign affiliates with parent companies. Among machine-building companies, global pipelines are actively developing to produce unified products for the world market, as well as the production of a "closed cycle" (manufacturing of goods for the US market in foreign assembly plants from parts and components supplied from parent companies) (Kozik, 2003).
The development of international cooperation causes the transformation of foreign trade into intrafirm (the movement of goods and services across the border between units
of one company located in different countries) (Kozik, 2003). Thus, the creation of developing harvesting plants on the territory of countries has led to the fact that more than 10% of the US trade with these countries is accounted for by intrafirm supplies. Similar links, often large-scale, are being developed by US with a number of industrialized countries. For example, in US imports from Germany, the share of such supplies exceeds 20% (Kozik, 2003).
Direct foreign investment has become global scale: the number of participants in this process is increasing and their positions are strengthening. The US role in this process also continues to grow, but due to the expansion of the club of international investors, the share of the US is relatively declining. A significant part of direct investment is concentrated in modern high technology branches of machine building (Kozik, 2003).
At the same time, the US as a separate country became the largest recipient of foreign direct investments. Intensive foreign investment in the American economy is an important sign of the strength (Kozik, 2003). Entrepreneurs of other countries, financing less technological sectors of the economy, thereby allow US capital to move into modern sectors, supporting the stability of the entire economic system of the country. In international economic, American capital is the main locomotive (Kozik, 2003).
The banking capital comes to the US on the basis of market regularities. Here it attracts high profitability, reliability of placement, prospects for future growth. In the global competition for financial resources, the US is winning due to its powerful potential, which generates economic growth on a new technological basis (Kozik, 2003). In the organizational plan, this movement is provided by the capacity and high degree of development of the domestic financial market. The scale of the domestic credit market is a powerful factor in the US influence on the global movement of monetary resources (Kozik, 2003). With the close interaction of money markets, their actual integration into the world market of credit resources, developments in the US money market, changes in the country's monetary policy significantly affect the overall state of affairs in the world economy (Kozik, 2003).
The international role of the dollar is at the core of the internationalization of the US monetary policy (Kozik, 2003). The dollar is the only benchmark for all currencies of developed countries. The reason for this is the need for international exchange to use a single universal settlement monetary unit. The universal settlement monetary unit should be a currency of a country that owns the role of the leader in the world economy. The US meets these requirements (Kozik, 2003). This means that all prices (oil, gas, gold,
aluminium, all minerals, all metals and their derivatives; food; weapons – everything) in the world economy are determined only in dollars. Therefore, to buy something on the world market you need to change your currency to dollars. So – to create additional demand for it (Starikov, 2011).
Today, the dollar is not only the main means of payment in international trade, but also the main means of accumulation. It is not the accumulation of citizens of different countries, but the accumulation of these countries themselves. The three-fourths of the Central Bank's foreign exchange reserves consist of dollars, the world's trade is accounted for more than a half in dollars, the dollar is a measure of the value of the most important commodities on the world market (Kozik, 2003). The so-called gold and foreign exchange reserves. Whichever country you take, there will be less gold in its reserves than currencies. Therefore, it would be correct to call such reserves currency-rich (Starikov, 2011).
2.3 Critical literature review
To study the influence of the Fed on the stability of financial markets, we need to examine the term “financial stability” and variables affecting it. There is no common definition for the “financial stability”. That fact makes the evaluation of the economy very complicated. Multiple researches have been done in the field, which developed diverse forms of macroeconomic models for measuring financial stability depending on the definition of the term.
The financial stability can be defined as a stable state in which the financial system effectively performs its key economic functions such as making payments, resource allocation and risk reduction (Podkuiko, 2007). Kydland and Prescott are creators of the Real Business Cycle (RBC) program. Models of the program are theory-based. They can repeat a pattern of business cycle fluctuations through the explicit function and chosen parameters. The models came from international trade history. Usually parameters of the models like that are not tested and not estimated, they are used as a “communication” and “illustration” mechanism and for a consistency check. The theory could be included in a class of computable general equilibrium (CGE) models (Bårdsen, Lindquist, & Tsomocos, 2006).
Bernanke, Gertler, and Gilchris introduced a new Keynesian model, that was classified as a Dynamic stochastic general equilibrium (DSGE) model with asymmetric information (Bårdsen et al., 2006). The financial stability was explained as the stability of
the financial situation, expressed in the balance of the finance sphere, sufficient liquidity of assets, the availability of necessary reserves (Podkuiko, 2007). Equilibrium framework is used to describe the relationship between firms’ investments and a financial variable. The stimulating contracts are defined by the model to decrease the chance of moral hazard through the decrease of asymmetry information (Bårdsen et al., 2006).
The model of Azariadis and Smith is included in class of overlapping generation (OLG) models with the asymmetry of information (Bårdsen et al., 2006). Financial stability is determined by trust in a financial system and it is capable of effectively allocating resources and absorbing shocks, preventing their subversive effects on the real economy or other financial systems (Podkuiko, 2007). The main input of the work lies in the fact that economies that have different wealth level can be moved toward steady states. It can be represented by financial system and capital accumulation. OLG models analyse the consequences of moral hazard that arose from the asymmetry of information (Bårdsen et al., 2006).
Goodhart, Sunirand and Tsomocos made contribution into Finite horizon general equilibrium (FHGE) class of models (Bårdsen et al., 2006). The model explains that financial fragility is an equilibrium point of the economy, where the equilibrium point is the balance of all the economic forces (Podkuiko, 2007). Thus, some actions should be done to prevent the crisis. Also, monetary and regulatory policies can be evaluated because monetary sector is included in the model. Therefore, the model is very flexible because it can be used with different storylines of risk in the banking system (Bårdsen et al., 2006).
Also, financial stability is defined as the absence of crises in the financial system, the financial sector is resistant to shocks in financial institutions or financial markets (Bårdsen et al., 2006). That definition was proposed by the bank of Norway (Podkuiko, 2007). Bårdsen and Nymoen created a macroeconometric model of Norwegian economy. It is a dynamic aggregative estimated (DAE) model. It explores the relationship between monetary policy and financial stability. At the present moment of time, model’s variables are closely connected to the macroeconomic conditions. More than that, a credit channel of the framework explains the financial markets’ rigidities (Bårdsen et al., 2006).
2.4 Analysis of Fed actions during the Financial Crisis 2007/2008
Before examining the influence of FRS on US and world financial markets, Fed’s crisis policies should be analysed. During the 2007-2008 financial crisis the Fed applied
conventional as well as unconventional measures. Monetary policy was used as a traditional step to prevent the crisis. The methods of monetary regulation of the FRS rely on the use of three instruments: required reserves for commercial banks and other lending institutions, discount rate, and open market operations. However, in modern conditions, the discount rate of lending is the most important and frequently used tool.
The change in the norms of mandatory reserves leads to a change in the size of the money supply. For instance, raising the rate of mandatory reserves leads to a decrease in the capacity of the bank. The supply of money and the potential for credit are narrowing. Bank loans are reduced and interest on them is increased (Chuvahina, 2012).
Open market operations mean that the Federal Reserve System buys or sells government securities from its member banks. This is the main tool that the Fed uses to raise or lower interest rates. When the Fed wants to raise interest rates, it sells securities to banks. This is called a restraining monetary policy. This slows down inflation and economic growth. When it wants to lower rates, it buys securities (Chuvahina, 2012).
The Fed rate is the interest rate of the US Federal Reserve System, which determines the value of domestic loans for the US banking system. The higher the rate, the more money borrowing banks have to pay for them. Lowering the rate means lowering the cost of loans. In the beginning of 2005, there was an increase in the business activity level. The growth of the economy was accompanied by inflation which was largely due to the increase in the world oil prices (Chuvahina, 2012). The US Federal Reserve System repeatedly raised the benchmark interest rate from 1% to 2.25%. In 2007 the value of the discount rate reached 5.25% per annum. Then, in March 2008, the rate was lowered to 3.25% in order to prevent the collapse of the US stock exchanges (Figure 1).
In 2010-2011, the rate remained in the range 0-0.25% of the defined interest, which is connected with attempts to reduce the deficit of the budget and, consequently, the growth of the state debt. The Fed kept the key discount rate in the range of 0-0.25% per annum in 2012, and reiterated the intention to keep the rate at exceptionally low levels until the end of 2014 (Chuvahina, 2012).
The economy continued to fall despite all monetary measures taken, the Fed moved to "using all available tools to promote economic recovery and preserve price stability" (FOMC, 2009). The FRS began to use non-traditional monetary policy instruments which were different before and after the bankruptcy of the Lehman Brothers Bank. This approach to use different methods was justified by the fact that the actions taken before and after had
Figure 1 The dynamics of discount rate (Vertical axis is the percentage; horizontal axis is the
date)
Note. Adapted from “Influence of the monetary policy of the Federal Reserve System on international financial markets,” by N.V. Pogrebnaya and V. A. Miheeva, 2017, Polytechnical network electronic scientific journal of
the Kuban State Agrarian University, (129).
fundamentally different nature and purposes for the methods of carrying out the policy (Chuvahina, 2012).
Before the bankruptcy of Lehman Brothers
The primary cause of the global financial crisis was the mortgage crisis that began in the US in 2007. It resulted from purchasing real estate on credit. Assumption was that the housing prices could only rise. However, after 2006 property prices started to fall (Figure 2), and interest on loans - to grow (Figure 3) (Kavitskaya, 2014).
The first program was The Term Discount Window Program (RAM) that began on August 17, 2007. That is a “special tool” that is used during the crisis when the federal funds market does not work properly. It enabled financial institutions to directly borrow from the Federal Reserve at a special discount rate that exceeded the federal funds rate. The discount rate was determined for each borrower, taking into account its rating and financial condition (Kavitskaya, 2014).
Since December 2007, the Fed had moved to the Term Auction Facility (TAF) program. This program included loans to banks and other depository institutions for 28 days through regularly held bi-weekly auctions. At these auctions, the Fed offered participants a fixed amount of liquidity that was paid to borrowers who offered the highest interest on the loan, but the average TAF rate was lower than the discount window rate (Kavitskaya, 2014).
Figure 2 House price growth, relative to 2001, based on across– metropolitan statistical
area (MSA)
Note. Elastic MSAs mean having a moderate increase in the price of a house in response to a big change in the demand. Adapted from “House prices, home equity-based borrowing, and the US household leverage crisis,” by A. Mian and A. Sufi, 2011, American Economic Review, 101(5), 2132-56.
Figure 3 Total debt growth, relative to 2001, based on across– metropolitan statistical
area (MSA)
Note. Elastic MSAs mean having a moderate increase in the price of a house in response to a big change in the demand. Adapted from “House prices, home equity-based borrowing, and the US household leverage crisis,” by A. Mian and A. Sufi, 2011, American Economic Review, 101(5), 2132-56.
The Term Securities Lending Facility was the next FRS program, which began operating on March 11, 2008. The bond lending program (TSLF) was in fact an extension of the TAF, unlike the TAF, it consisted of regular (once a week) lending to treasury obligations USA (US Treasuries). At the same time, the list of securities accepted by the
Federal Reserve as a collateral was significantly expanded: it included commercial mortgage-backed securities, not lower than AAA, along with the securities of Fannie Mae and Freddie Mac. The peculiarity of this program was that the FRS took as a pledge not the most highly liquid bonds traded on the market with a significant discount, issuing US Treasuries as security (Kavitskaya, 2014).
The fourth in this line of programs was the Primary Dealer Credit Facility, which was launched on Sunday, March 16, 2008. In the framework of lending to primary dealers, the Fed extended the possibility of access to the modified discount window, allowing new participants there, and also supplemented the list of securities serving as collateral (Kavitskaya, 2014).
In general, as a result of these programs, the FRS managed to increase the timeframe for borrowing money from the Fed, the list of securities accepted by the Federal Reserve as a collateral for loans was significantly expanded, a more flexible system of interest rates for loans was extended (Kavitskaya, 2014).
After the bankruptcy of Lehman Brothers
Before moving to a quantitative easing policy, the Fed took a number of steps to stabilize certain sectors of the financial market. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility was the first program of this kind. The goal of the program was to help the money market funds that faced a shortage of cash to prevent investors from withdrawing their assets. This program envisaged lending to banks for the purchase of asset-backed commercial papers from money market funds (Kavitskaya, 2014). The emergence of such a program was due to the special role of the Money Market Mutual Fund (DDR) in the functioning of the financial market. FDRs are investment funds in money market instruments, that is highly liquid term securities, for example, short-term treasury bills. On September 15, 2008, when Lehman Brothers Bank declared bankruptcy, the oldest Fund of the US Money Market - Reserve Primary Fund, which owns the debt obligations of this bank for $ 785 million, had to write off a part of this sum as a matter of urgency. The next day, the fund's shares lost parity with the dollar, dropping to 97 cents per share. One of the security criteria for any investment fund is the ability to keep the value of its shares at least at the level of parity with the US dollar. Therefore, when the oldest Money Market Fund in the US showed weakness, many investors of other large funds began to withdraw investments. At the same time, many investment banks and companies continued to issue securities worth billions of dollars, thereby exposing other investors and capital markets around the world to serious systemic risks. To calm the
markets, the Fed in September 2008 began a program to finance the repurchase of commercial securities from mutual funds of the money market. The second step in this direction was the Commercial Paper Funding Facility (CPFF), in which the FRS financed the purchase of high-quality, unsecured and secured commercial papers by primary dealers (October 2008-January 2010). The issuers bought out both secured and unsecured commercial paper to support the liquidity of commercial structures (Kavitskaya, 2014).
These programs supported short-term financial markets and increased the availability of credit through various mechanisms. Nevertheless, the demand for some distressed assets could not be stimulated by providing loans. Such assets were mortgage bonds: mortgage-backed securities (MBS) (Kavitskaya, 2014).
The Fed resorted to quantitative easing for the further recovery of the economy after the collapse of Lehman Brothers. In March 2009, the Fed for the first time announced the purchase of long-term government bonds (QE1). Thus, only in the framework of QE1, securities worth over $ 1.75 trillion were purchased. In August 2010, the Fed decided to keep this volume of liquidity at the same level through the reinvestment of principal payments on agency debt securities and mortgage-backed securities in the US government bonds. There was a very slow recovery in output and employment. Therefore, in November 2010, the Fed announced further expansion of the balance by buying an additional portion of long-term US Treasuries worth about $ 600 billion at $ 75 billion per month (QE2) (Kavitskaya, 2014).
After the end of the second series of quantitative easing operations, the Fed announces the launch of the so-called Maturity Extension Program (MEP), a program to extend the term of securities in the FRS portfolio. This program was a purchase of long-term US Treasuries and sell for a similar amount of short-long-term government bonds (Kavitskaya, 2014).
The reason of MEP is a deterioration of macroeconomic indicators, downward revision of the forecasts and stable expectations for the inflation. To prevent the inflation, spiral from spinning, on the 21-st of September, 2011, there was made a decision about a qualitatively different round of stimulus measures that the US Federal Reserve had already implemented in 1961 (Operation Twist) (Kavitskaya, 2014).
The Federal Reserve System began to rebalance its portfolio by selling short issues and replacing them with issues longer ($400 billion until June 2012, in June 2012 the program was extended until the end of 2012 with an increase to $267 billion). As a result, the slope of the US Treasury bond curve changed, the rates at the long end of the yield
curve of the bonds, which are benchmarks for mortgage rates, fell. The yield spread of long and short issues for the duration of the program was reduced by almost 150 basic points (b. p.) (Figure 4).
In September 2012, the US Federal Reserve makes a decision to launch the third LSAP (or QE3) program for the purchase of assets secured by mortgage-backed securities (MBS). In December 2012, the Fed prolonged LSAP3 (Kavitskaya, 2014).
The Open Market Committee (FOMC) of the US Federal Reserve makes a decision to complete QE3 in October, 2014 because the US economic activity increased, the situation on the labour market improved, household expenditures increased, and the investment of entrepreneurs in fixed assets became higher. The asset purchase program was completed by the committee, but in order to support employment growth and price stability, the corridor for the Fed rate in the range of 0 to 0.25% was saved (Kavitskaya, 2014). Figure 4 Spread of 10-year and two-year Treasury bonds, USA, b. p.
Note. Adapted from “Monetary policy during the crisis: common goals and different practices,” by T. A. Tsilyurik, 2013, Financial analytics: problems and solutions, (47).
3. Methodology and Empirical analysis
3.1 Describe empirical model
In my research, I use the definition of Baur and Schulze (2009), who explained it as “a constant impact of systematic shocks in normal and extreme market situations”. Financial stability is a part of systematic shocks and is a necessary component of our regression model.
I want to examine the stability of the financial markets from 01/01/2005 till 01/01/2017. The longevity is determined by the need to cover multiple cycles of the crisis development. The first one is 01/01/2005-14/09/2008 - pre-crisis period, 15/09/2008-31/01/2010 is a period of the crisis (after the Lehman Brothers crash that happened on the 15-th of September, 2008). 01/02/2010-01/01/2017 is the post crisis.
I performed two regressions for each of the periods to explore stability of the US and the World financial markets. S&P 1,500 and MSCI World indexes representing the US & the global economies. I applied the daily continuously compounded index returns for both indexes using quantile regression model.
Quantile regression is a procedure for estimating parameters of a linear relationship between explanatory variables and a given level of quantile variable. Unlike the ordinary least-squares method (OLS), quantile regression is a nonparametric method. It allows to get more information: regression parameters for any quantiles of the distribution of the dependent variable. In addition, such a model is much less sensitive to emissions in data and to violations of assumptions about the nature of the distributions (Koenker & Hallock, 2001). It gives better explanation of the effect of each independent variable on the dependent variable (Fabozzi, Focardi, Rachev, & Arshanapalli, 2014).
rt=a+bft*+vt;
Qr(|ft*)=a()+b()ft* where:
rt - a market return of a stock at time t;
a - is a constant;
ft* - systematic shock at time t, it is a shock that influences the whole market. Cannot be diversified;
vt - idiosyncratic shock of a stock at time t, it is also known as unsystematic or
Qr(|ft*) - -th conditional quantile of rt that is linearly dependent on ft* (Baur & Schulze, 2009).
If b is a constant, so it stays the same over all quantiles, it means that financial market is stable (Baur & Schulze, 2009). However, if financial market is not stable, b will be higher for smaller quantiles meaning the market could be influenced by shocks that took their roots from financial market system in negative market conditions rather than in the normal state (Baur & Schulze, 2009).
To evaluate the US financial market stability during the chosen time frames, I used the joint F-test with three degrees of freedom for all the periods to identify the acceptance or rejection of the hypotheses (Baur & Schulze, 2009).
3.2 Hypothesis
It is expected that the financial markets should NOT be stable during the period of the crisis (15/09/2008-31/01/2010) while the periods before and after were expected to be stable.
For all time intervals, the null hypothesis of 1%, 5%, and 10% conditional quantiles are equal to the conditional median (50%), so the market is stable; while the alternative hypothesis is that there is at least one inequality, the financial market is unstable.
H0: q1=q2=q5=q50
H1: at least one of them is not equal
3.3 Output and analysis
Table 1 represents that during the period from 01/01/2005 till 14/09/2008 it was found that both the US as well as the world financial markets were not stable. To examine the stability, we used F-test with 3 degrees of freedom. Its critique value was 3.8020023. F-test values were 8.76 and 6.78 (Table 1) for the world and US regressions respectively. F-critique was lower than the F-values of the regressions, therefore it could be concluded that there was enough evidence to reject H0 and it meant instability of financial markets during the first analysed period. In Table 2 q1, q2, and q5 were compared with q50 because it was an estimation of the smallest absolute deviations. Also, higher quantile meant more stable financial market. Decreasing coefficients from q1 to q50 meant that the more stable market was less likely to undergo shocks due to financials conditions.
The result of the quantile regression was completely the opposite to what was expected. However, the output could be explained through the financial processes that were happening during that time. In my research, the collapse of Lehman Brothers was an event that separated the period before financial crisis and the period of financial crisis itself. Originally it all started with the subprime mortgage crisis in 2006 when the real estate prices started to fall.
Table 1 Test for financial market stability
LIBOR fluctuated a lot and started to grow significantly after 2004. In 2006, it reached 4.29% per annum, and by the end of 2007 it had reached 6%. The borrowers could no longer pay on loans. As the result, since the beginning of 2007, the number of defaulted borrowers had started to increase driving the crisis from the real sector of economy into subprime. The tenth largest companies on the market, American Home Mortgage, was the first victim of the American crisis. It owned 2.5% of the total US loan market and accounted for $4 billion.
As it was predicted, both financial markets were unstable during the crisis, from 15/09/2008 till 31/01/2010. F-critique is 3.836756. 7.83 and 8.57 (Table 1) are F-values for the world and US regressions respectively. F-values are higher than F-critique, thus we can make a conclusion that there is enough evidence to reject H0 and it means instability of financial markets during the examined time period.
The great financial crisis of 2008 / 2009 was the main reason of instability during the period. Oil prices fell from $147 per barrel to less than $40. Car sales dropped globally by 16% in 2008, and in the US by 26%, which led to a decrease in demand for metals. All those factors led to reduced product needs driving significant layoffs in the industrial and engineering industries and causing economy to shrink even further.
T ab le 2 Re sult s of quanti le re gre ssi on
For two years of the crisis (2008-2009), the largest respectable investment banks with a hundred-years history were burnt down. Merrill Lynch was swallowed up by Bank of America while Solomon Brothers and Morgan Stanley changed their status: the investment activity was replaced by a commercial one.
Immediately after the United States, the European economy suffered a severe impact of the financial crisis. Iceland, Britain, Germany, Russia and other countries started to follow the US.
During the post crisis period 01/02/2010-01/01/2017 it appeared that the US was not stable, however, the world financial markets met our expectations. 3.7924904 is F-critical with 3 degrees of freedom. It is higher than the 0.98 for the world and lower than 5.53 for the US regressions. Hence, we can make a conclusion that there is enough evidence to reject H0 and it means instability of the US financial markets while there is not enough information to reject the null hypothesis for the world market and it means that the financial market was stable.
After the crisis, the economy recovered and world financial market was stable, however, the US market had an opposite situation. Global recession could be one of the reasons of instability. Also, there was a lot of consequences of the crisis that still had their effect on the economy’s recovery. For instance, there were recorded more than 485 bank failures from 2007 to 2012, then a drop of automobile production could not be recovered very fast, the crisis extended to the related industries such as insurance, construction, crediting, and many more.
4. Discussion of results
The impact of the monetary policy of the Fed on international financial markets can be judged differently. First of all, it is important to pay attention to the influence and reaction of the local securities market after the decisions of the banking regulator to soften or tighten its monetary and credit policy. The key instrument of the Fed's influence is the interest rate, but, after the crisis of 2008-2009, the world saw new instruments of monetary stimulation, which were called QE programs. The most popular program was QE3 (Pogrebnaya & Miheeva, 2017).
In order to reflect the impact of the monetary policy of the Fed on the American securities market, it is necessary to analyse key instrument dynamics with the path of US interest rate changes. The main stock market instrument is the stock index S&P 500, among the components of which are 500 the largest American corporations. Their total capitalization is greater than the total GDP of the US. Moreover, the stock index S&P 500 is the key financial asset of the entire international financial market (Pogrebnaya & Miheeva, 2017).
The "bearish" trend of the stock index S&P 500 began in late 2007. The Federal Reserve System decided to start a period of interest rate cuts to stimulate the country's economic growth, including the mortgage and US stock markets (Pogrebnaya & Miheeva, 2017).
The market fall slowed down after the Fed reduced the interest rate to the historical minimum of 0.25% on December 16, 2008. Due to the decrease of the interest rate and increase of cheap money in the economy, there started to rising again and by April 2013 the S&P 500 reached its historical maximum. One of the main reasons for growth was FRS’ quantitate easing program called QE (Pogrebnaya & Miheeva, 2017).
Initially, the Federal Reserve System introduced the first and second quantitative easing programs (QE1 and QE2), which did not bring the expected effect that was reached with QE3. The key goal of the program was to stimulate inflation, and to improve the position of a labour market what was considered as the cause of all problems of the American economy.
Later, the labour market showed its growth, the US economy rose more than 2-2.5% a year, but there was no increase in inflation. This was confirmed by the dynamics of the S&P 500, because during the QE3 program it had the “bullish” trend (Pogrebnaya & Miheeva, 2017).
The Fed's policy became the reason for the growth of all the world's stock markets. The level of correlation between countries is too high. For example, analysing the dynamics of the profitability of a 10-year Treasury bond from 2007, it is possible to draw certain conclusions: first of all, higher demand for the paper lowers its profitability. Therefore, the programs of quantitative easing caused a decline in the yield of this instrument. In the beginning of the crisis, the Treasury yield was about 4%. In 2007, it was even higher 5%. Their yield dropped below 1.5-2% when the Fed adhered to an extremely soft monetary policy. This is a confirmation that the Fed's monetary policy affects not only the US stock market and all world stock markets, but also the debt securities market (Figure 5) (Pogrebnaya & Miheeva, 2017).
Taking German bonds and dynamics of their profitability, it can be observed that the correlation level of 10-year US and German bonds (Figure 6) is extremely high. The reason for the decline in the yield of US bonds was the monetary policy of the Fed, and German bonds reacted to this event by going in the same direction. The reason for this correlation is the high level of globalization and integration. For this reason, changes in the monetary policy of the Fed trigger a reaction around the world. However, the cause for this dynamic of German bonds is the monetary policy of the European Central Bank. Throughout 2016, the yield of securities reached a negative level of -0.15%, which was the reason for the negative rate of the ECB, but, such monetary policy of other Central Banks is explained by events around the Fed.
Figure 5 10-year treasury bonds yield
Note. Adapted from “Influence of the monetary policy of the Federal Reserve System on international financial markets,” by N.V. Pogrebnaya and V. A. Miheeva, 2017, Polytechnical network electronic scientific journal of
the Kuban State Agrarian University, (129).
Figure 6 10-year Germany Government bond
Note. Adapted from “Influence of the monetary policy of the Federal Reserve System on international financial markets,” by N.V. Pogrebnaya and V. A. Miheeva, 2017, Polytechnical network electronic scientific journal of
More than that, the events of 2007-2008 could be unfolded in order to find out the reaction of other Central Banks to the monetary policy of the Fed. For instance, the Fed was the first who mitigated and reduced the interest rate. On the contrary, the European Central Bank and the Bank of England increased their interest rates slightly to an insignificant level, but later, at the end of 2008, they began to lower their interest rates sharply (Figure 7) (Pogrebnaya & Miheeva, 2017).
Figure 7 Interest rate of the FRS, ECB, Bank of England, and Bank of Japan (2007-2008)
Note. Horizontal axis is the interest rate, vertical axis is the date. Orange is the Federal Reserve System; red is the European Central Bank, blue is the Bank of England, and yellow is the Bank of Japan. Adapted from “Influence of the monetary policy of the Federal Reserve System on international financial markets,” by N.V. Pogrebnaya and V. A. Miheeva, 2017, Polytechnical network electronic scientific journal of the Kuban State Agrarian
University, (129).
The reason for this is the reaction of the rest of the world to the events in the US economy. It does not mean that the monetary policy of the Fed is a key reference point for other banking regulators, despite of the fact that its role and importance should not be denied. The first negative events were observed in the US economy, so, the FRS was the first to react. Then, the failure of the S&P 500 exchange index and the US mortgage market happened and they caused the financial collapse in other markets of the world. Therefore, they became fundamental factors of the soft monetary policy of the ECB, the Bank of England (Pogrebnaya & Miheeva, 2017).
In addition, the Fed has a big impact on financial markets, such as commodity and raw materials including energy, and the FOREX markets. It could be seen through the monetary policy of the FRS and the dynamics of the oil market.
In order to assess the change in the dollar's exchange rate, it is worth analysing the key currency pair of the FOREX EUR / USD market.
Therefore, there are no doubts that FRS has an effect on the US and world financial markets, however, depending on the taken measures the results may vary from short-term to long-term. Moreover, the results of regressions show that during the first two studied intervals both markets were unstable. That highlights the dependence of the processes of one market to another. The third interval showed opposite results for the market stability, but only the future research may discover its reasons, more time should pass to have a complete overview of the situation.
5. Conclusion
It can be concluded the policy of the Fed affects not only the international financial market, but also the real sector of the economy of all countries. As a result of ongoing active intervention, the Fed began to play a much more important role in the US economy than it was before the crisis. Its financial weight has grown significantly. Moreover, the monetary authorities began to resort more actively to the levers of influence available to them.
Before the crisis, the US Federal Reserve System was limited to the acquisition of relatively small government bond packages and it was mainly focused on the controlling of the level of inflation. By 2013, the expert community came to a thought that the actions of the Fed influence inflation, the exchange rate, economic growth, interest rates for a wide range of loans, and even the unemployment rate.
Unconventional monetary policy of the United States allowed to avoid significant risks of both deflation and economic spree. As a result of implementing its policy, the Fed had three undoubted achievements, which played a key role in restoring the American economy. The first one was the stabilization of financial markets and the renewal of the normal operation of the US banking system. There was a sharp decline in systemic risks. Secondly, the Great Depression with catastrophic consequences was prevented, and the third achievement of the Fed was a radical reduction in interest rates (Zaharov, 2013).
The substantial results are found by using the quantile regression for the period from 2005 till 2017 for the exploring of financial stability of US and world markets, however, there are still some limitations. The independent variables of the model could be extended using new and more modern definition of financial stability. In addition, when it comes to
the research goals for the future, since some of the results are not consistent with the expectations, the work can be replicated to explore the dynamics of modern trends.
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