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Fed’s Asset Purchases Result in Increased Market Volatility

May 18, 2024

Fed’s Asset Purchases Result in Increased Market Volatility

“Once again, the empirical evidence supports reigning in the Fed; the economy works better when the Fed does less, not more.”

The Federal Reserve underwent a massive regime shift following the 2008 financial crisis. It incorporated several new tools into its monetary policy arsenal, ranging from interest on excess reserves to large‐​scale asset purchases (“quantitative easing”) to deal with the crisis. Unfortunately, as with most public institutions, power given is seldom relinquished.

As a recent Cato CMFA article noted, if the Fed is expected to massively increase its balance sheet in response to every major crisis, it will never return to a pre‐​2008 operating system. Furthermore, the COVID-19 pandemic spurred a further round of massive quantitative easing, so much so that instead of shrinking back down, the Fed’s asset holdings are now over one‐​third the size of the entire US commercial banking sector.

It stands to reason that such a massive shift in central banking should have effects on the financial system. A recent Wall Street Journal opinion piece makes this argument and uses options market data to suggest that the Fed’s involvement in financial markets has increased stock market volatility.

To be fair, the article points out a singular observation, one which may not reflect any underlying trend.

But there are ways to check for any underlying trend, such as vector autoregressions (VARs). In this post, I use a VAR method and demonstrate that the Fed’s 2008 regime shift has indeed had serious repercussions for market volatility as measured with the CBOE Volatility Index (“VIX”). (For those interested, I provide more details on the methodology after discussing the results.)

…click on the above link to read the rest of the article…

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