One good market regurgitation, and the 911 call goes out: Alan Greenspan, where are you when we need you?
For the past few months, the US stock market has suffered periodic episodes of vertigo - about one per week - usually on news of something foul in the subprime market, after which it goes back to scale new heights.
Last week something happened. The stock market had three bad days, one of which was really bad, as investors abandoned all sorts of risky assets for the safety of US treasury securities.
What was most interesting about last Thursday’s 312-point dive in the Dow Jones Industrial Average - the Dow was off 450 points at its lows - was how quickly financial futures markets started to entertain the notion that the Federal Reserve might ride to the rescue with an interest rate cut in the fourth quarter of this year.
“In the last 48 hours, the Fed funds futures had the biggest change in outlook for Fed policy in months,” Jim Bianco, president of Bianco Research in Chicago, said in a phone interview last Friday. “Two weeks ago, there was no ease priced in until September 2008, the last contract that trades.”
It was two weeks ago that Fed chairman Ben Bernanke presented the central bank’s semi-annual monetary policy report to Congress and reiterated the long-held view that inflation remains the predominant policy concern.
What happened in the interim to change that risk, at least in the eyes of those who traffic in interest rate futures?
The stock market took a dive.
“It’s right out of the Greenspan playbook,” Bianco said. “In addition to all the other wonderful things the Fed does, such as promoting stable prices and maximum employment, under Greenspan, the Fed set out to make sure that brokerage statements had the highest return possible.”
This is not the Greenspan Fed. The “Greenspan put” retired with the former chairman in January 2006.
A put option gives the buyer the right to sell a security, commodity, index or futures contract at a specific price by a specific date. Buying a put protects the holder against a decline in prices.
The “Greenspan put” entered the lexicon after several stock market rescue efforts: Greenspan cut the overnight Federal funds rate in 1995 following the Mexican peso crisis and Orange County, California, blow-up and again in 1998 in response to the near-collapse of hedge fund Long-Term Capital Management. Investors came to refer to, and rely on, the Greenspan put as an implicit guarantee that Fed would cut rates if things got too dicey in the stock market, which had become the national pastime in the late 1990s.
Means to an end
Greenspan inherited a 4.2% inflation rate - using the core consumer price index (CPI) - from Paul Volcker in August 1987 and cut it in half in 18 years. Volcker had already done the heavy lifting, cutting core inflation from its 1980 peak of 13.6%.
While Greenspan was considered an inflation fighter, in reality he placed more emphasis on achieving maximum sustainable employment than Fed’s other mandate, price stability, according to Joe Carson, director of global economic research at AllianceBernstein.
“Greenspan was much more willing (than Bernanke) to move official rates up or down if changes in current or prospective economic conditions were perceived as a threat to the quest for maximum employment (or growth) and ultimately to price stability,” Carson wrote in a recent report for clients. Rather than speed limits for growth or ceilings for inflation, Greenspan “focused instead on the imbalances that would engender economic and price strains”, he said.
Dogs at bay
For example, core inflation has been above Fed’s comfort zone of 1-2% for some time. Bernanke has given no sign that he is contemplating a rate cut, even in the face of a housing recession and below-trend growth last year.
The core CPI rose 2.2% in the 12 months ended June, down from a recent peak of 2.9% in September 2006.
That inflation rate didn’t pose a hurdle to Greenspan, who cut rates 16 times in the last decade of his tenure with core inflation at 2.2% or higher “because other economic or financial imbalances were more pressing at the time”, Carson said.
Cut to the chase: If Greenspan was Fed chairman, would he be cutting rates now? Probably not, Carson said, but he’d be leaning in that direction. One can imagine him making an elaborate argument that the only reason the core CPI is above 2% is “because CPI housing costs are based on imputed rents, not actual prices”, Carson said.
Greenspan was nothing if not flexible.
The Pavlovian response in interest rate futures markets last week—stocks down, Eurodollar and Fed funds futures prices up—demonstrates how hard it is for traders and investors to let go of expectations that Fed will respond to any and all crises.
“The definition of a crisis in the Greenspan era was any market environment preventing a trader from getting 100% of his bonus potential,” Bianco said. “We still operate like that.”
Bernanke is trying to wean the market from that form of life support. It’s a slow process, and during times of stress, old habits reassert themselves.
At times like these, it’s important to remember that “Greenspan is no longer Fed chairman”, Bianco said. “It’s a dirty little secret that not too many people know.”
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