Whatever it Takes? The Impact of Conditional Policy Promises

The announcement of an economic rescue tool often comes with implicit promises of more intense intervention if conditions worsen. We propose and implement a method to identify conditional policy promises and quantify their impact using data from options markets. When the Federal Reserve introduced corporate bond purchases during the COVID-19 crisis, markets expected five times more price support in crash scenarios relative to the median case. This implicit promise to significantly expand the size of the intervention in bad states explains half of the market response to the announcement. Furthermore, we document that the behavior of the price and tail risk of corporate bonds remains substantially distorted even after purchases have ceased. We confirm the pervasive influence of conditional promises across several policy announcements: U.S. quantitative easing, Bank of Japan asset purchases, bank equity injections in 2008, and FOMC releases. ∗Haddad: UCLA & NBER, valentin.haddad@anderson.ucla. edu; Moreira: University of Rochester & NBER, alan.moreira@simon.rochester. edu; Muir: UCLA & NBER, tyler.muir@anderson.ucla. edu. We thank seminar participants at UCLA, LBS, USC, the Federal Reserve Board, UT Dallas, and Temple for comments. Policy announcements are often perceived to come with promises, implicit or explicit, of more intense intervention if conditions worsen. The presence and role of these promises is intensely debated, particularly in the context of policies supporting financial markets and institutions as a way to stimulate the economy. For example, the Federal Reserve’s purchases of corporate bonds during the COVID-19 crisis sparked criticism due to the concern that further interventions any time markets crash could distort prices and create moral hazard issues. Others instead argue that commitment to more intervention makes policies more effective, a view exemplified by then-ECB director Mario Draghi’s “whatever it takes” approach to the 2012 sovereign debt crisis. Finally a third camp, common in much economic research, ignores promises altogether and takes policy announcements at face value. Despite the importance of these issues, quantitative evidence on promises is scarce because they are often involuntary, implicit, or simply vague. In this paper, we propose and implement a method to measure conditional promises contained in policy announcements and their impact. Our method uses changes in the distribution implied by option prices before and after policy announcements to characterize the impact of policy across many possible states. We find pervasive evidence of the role of conditional promises, that is, larger interventions in bad states, across many financial stabilization policies including corporate bond purchases during the COVID-19 crisis, U.S. quantitative easing, asset purchases by the Bank of Japan, and bank capital injections during the 2008 crisis. Consider the Federal Reserve’s corporate bond purchases during the COVID-19 crisis, our primary empirical setting. With the expansion of the pandemic, corporate bond markets tumbled during the first quarter of 2020. On March 23rd, the Federal Reserve made the unprecedented announcement that it would purchase up to $300 billion of investment-grade corporate bonds. Investment-grade corporate bonds recovered by about $500 billion in value immediately after the announcement was made, and they recovered by about $1 trillion in total within three days. A few months later, the purchases occurred