INDEX INTELLIGENCE: Rolling Forward the "Greenspan Put"

If the Federal Reserve is prepared to help the financial markets, it wouldn’t be unprecedented. Indeed, former Fed Chairman Alan Greenspan, known in some circles as “Easy Al,” was often criticized for acting too swiftly during times of market volatility. For example, after the tech bubble exploded in 2000, Greenspan’s administration lowered rates eleven times over the course of one year.

The Fed Chairman’s willingness to intervene and help financial markets gave rise to the notion of a “Greenspan put.” Put options are often used to protect a stock or portfolio from a move to the downside. The term “Greenspan Put” was based on the idea that the Federal Reserve would take steps to help the US financial markets during times of volatility and falling stock prices.

But, what exactly can the Fed do now? Well, Greenspan can’t do much anymore. He stepped away from the Fed in early-1996 and is now following other pursuits, including serving as an advisor to Deutsche Bank. Now, Ben Bernanke heads the US Central Bank.

Bernanke is a graduate from Harvard with a Ph.D. from MIT. He is one smart cookie and also known as a creative thinker. Shortly after being appointed Federal Reserve governor in August 2002, for instance, he explained that, rather than accept deflation in the economy, “the US government has a technology, called a printing press.” [Deflation: Making Sure It Doesn’t Happen Here, November 21, 2002.] Needless to say, printing money to offset deflation is not a conventional approach to monetary policy. Some might call it reckless. Nevertheless, his willingness to take some unconventional approaches—to think outside the box—makes him somewhat different than other recent Fed chiefs.

Bernanke’s creativeness was on display last week when the Federal Reserve surprised the market by unexpectedly lowering the discount rate, which is the rate that the Fed charges member banks for short-term loans. The move was designed to help some of the financial institutions that are currently facing a credit crunch, which resulted from complex securities that held subprime mortgages. The risk embedded in these securities, known as asset-backed securities [ABS], were seriously underestimated by the credit agencies. Now that the true nature of these volatile beasts has surfaced, there has been an industry-wide withdrawal of credit by financial institutions and other lenders. Risk aversion is at an extreme. The Fed lowered the discount rate (and increased the timeframe for loans) in order to make more funds available to banks. It was the right move.

Yet, while lowering the discount rate is a smart play in the context of the current credit squeeze, the Fed has other tools at their disposal. For one, the Central Bank has already been pumping liquidity into the financial markets by making more funds available to banks. It, along with European Central Bank and the Bank of Japan, have been pumping billions of dollars into the market daily.

Second, and more important, is the federal funds rate. The federal funds rate is the rate on overnight loans between member banks. It is the interest rate that an institution lends available funds (extra reserves at the Fed) to another institution. The Federal Reserve, through its Federal Reserve Open Market Committee [FOMC] which meets every six weeks to discuss the outlook for the economy, sets a target for the fed funds rate. In addition, since the Fed has considerable control, it can attempt to stimulate the economy by lowering the rate or the FOMC can attempt to restrict economic growth (inflation) by raising the fed funds rate. After Greenspan cut the rate from 6.5% in mid-2000 to only 1% three year later, seventeen consecutive hikes have pushed the fed funds rate back to 5.25%.

Now, since the Federal Reserve has lowered the discount rate to help the financial markets, there is also speculation that it will also cut the federal funds rate at its next meeting in September. Indeed, in the trading pits, the Fed Funds rate is already below 5%. According to Reuters, the Federal Funds rate was trading at 4.875% late Tuesday, well below the Fed’s target rate of 5.25%. The fact that the Fed Funds rate in the marketplace is now well below the Fed’s target rate signals a strong chance for a rate cut at the next Federal Reserve Open Market Committee meeting on September 18. Some market watchers believe that the Fed could act even sooner with an intra-meeting cut if the credit problems don’t show signs of improvement in short order.

So, it seems possible that the “Greenspan Put” has now been rolled over to the Bernanke era. The Federal Reserve has signaled that it is willing to help banks during the latest credit squeeze and the financial markets are pricing in the chance of a rate cut in September. Stocks are regaining lost ground.

Importantly, however, it doesn’t necessarily follow that the Fed will be equally willing to bail out the stock market in order to support higher prices in the future. In other words, the Federal Reserve might see the credit squeeze as a risk to the economy. A falling stock market is another matter. Richmond Federal Reserve Bank President Jeffrey Lacker said Tuesday, “Financial market volatility, in and of itself, does not require a change in the target federal funds rate.”  In conclusion, if the stock market has been rallying since Friday on the view that the Fed will “put” a floor under stock prices, the risk to investor confidence in the future is that the Fed is really responding to the credit worries, and not the problems on Wall Street. That is, with Bernanke at the head of the Fed, the “Greenspan Put” has long expired. 

Frederic Ruffy
Senior Writer & Index Strategist
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