Janet Yellen is leaving the Greenspan “put” behind as she charts the first interest-rate increase since 2006 amid growing financial-market volatility.
The Federal Reserve chair has signaled she wants to place the economic outlook at the center of policy making, while looking past short-term market fluctuations. To succeed, she must wean investors from the notion, which gained currency under predecessor Alan Greenspan, that the Fed will bail them out if their bets go bad -- just as a put option protects against a drop in stock prices.
“The succession of Fed puts over the years has led to a wide range of distortions in financial markets,” said Lawrence Goodman, president of the Center for Financial Stability, a monetary research group in New York. “There have been swollen asset values followed by sharp declines. This is a very good time for the Fed to move away.”
When Fed officials met in October, two weeks after the Standard and Poor’s 500 Index wiped out all of its gains for the year, they discussed adding a reference to market turmoil in their statement. They rejected the idea to avoid the “misimpression that monetary policy was likely to respond to increases in volatility,” according to minutes of the meeting.
“Let me be clear, there is no Fed equity market put,” William C. Dudley, president of the New York Fed, the central bank’s watchdog on financial markets, said in a Dec. 1 speech in New York. “Because financial-market conditions affect economic activity only slowly over time, this suggests that we should look through short-term volatility.”
Bolstering the Fed’s resolve is a banking system that’s more resilient to market shocks today than it was during Greenspan’s 18-year tenure that ended in 2006.
One lesson former Chairman Ben S. Bernanke brought to the Fed during the financial crisis, however, is that widespread aversion to risk amid financial panics can accelerate economic declines. Fed officials are committed to avoiding those incidents and now incorporate detailed analysis of financial-system risk into their monetary-policy discussions.
The Fed’s determination to look past market fluctuations could be tested as market rates defy the Fed’s prediction that the economy will warrant higher borrowing costs soon.
Yields on U.S. government 30-year bonds fell to a record low Jan. 14 on fears of spreading disinflation. The Bloomberg Commodity Index reached its lowest level since 2002, and traders are increasing bets that the Fed won’t raise interest rates until at least the end of the year.
Laura Rosner, U.S. economist at BNP Paribas in New York, says the Fed is likely to pay attention to how financial conditions and incoming data are affecting its medium-term outlook rather than fixate on particular market signals.
The policy-making Federal Open Market Committee “is anchored on the medium-term outlook,” said Rosner, who worked at a unit of the New York Fed charged with monitoring markets daily. “That is what’s steering policy despite an aggressive oil-price shock.”
The concept of a Fed put took hold under Greenspan, who in 1998 cut the benchmark federal funds rate three times in response to market stress arising from a Russian bond default and the failure of hedge fund Long-Term Capital Management Inc.
The economy expanded 5 percent that year and 4.7 percent in 1999, and critics say the rate cuts helped extend a bubble in technology stocks. The Nasdaq Composite Index rose 40 percent in 1998 and 86 percent in 1999 before plunging almost 40 percent in 2000. The bursting bubble helped end the longest expansion in U.S. history with a recession that began in March 2001.
Joke to Greenspan
Greenspan, now a private economist, said in an interview that he regarded the notion of a Fed put as a “joke.” Cutting rates to add temporary liquidity to ease panicky financial conditions is what central banks have always done, he said.
Still, Greenspan operated in a world where leveraged investment banks, which had no access to depositors or the Fed’s discount window, needed short-term funding to keep credit flowing to the economy as they packaged and traded consumer debt in the form of asset-backed securities.
In the wake of the 2008-2009 financial crisis, large brokers such as Goldman Sachs Group Inc. have become banks or, in the case of Merrill Lynch, have been purchased by banks that can support their liquidity needs. Regulators are also pushing bank holding companies to make themselves less vulnerable to runs by holding more capital and maintaining large liquidity buffers.
“Financial volatility occurs when you have highly leveraged institutions,” Greenspan said. “But if you have institutions with significant capital buffers, volatility will be muted.”
U.S. central bankers are counting on supervisory tools, such as their current stepped-up focus on lending standards in the high-yield loan market, and higher levels of bank capital and liquidity to help make the financial system more resilient to shocks.
The so-called Tier 1 capital ratio, a core measure of a bank’s strength comparing capital to risk-weighted assets, more than doubled to 11.6 percent at the end of 2013 for the 30 largest banks compared with the first quarter of 2009, according to the Fed’s most recent stress-test report issued last March.
“They feel they have taken steps so they don’t have to use monetary policy to stabilize the system,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.
Bernanke also tried to steer away from policy shifts that respond to markets.
He urged the Fed to publish its forecasts for the economy four times a year partly to focus both policy makers and the public on the medium-term outlook.
When the financial crisis hit in 2007, Bernanke’s first response was to cut the discount rate, the price the Fed charges banks for direct loans, rather than the federal funds rate. While the fed funds rate influences borrowing costs throughout the economy, lending through the discount window has the narrower aim of lowering costs for banks that need short-term cash.
“The direct evidence of a slowdown is not yet here,” Bernanke told Fed officials in an Aug. 16, 2007, conference call as they prepared to cut the discount rate, according to transcripts. Bernanke recommended resisting a cut in the fed funds rate “until it is really very clear from economic data and other information that it is needed. I’d really prefer to avoid giving any impression of a bailout or a put, if we can.”
Nobody thinks Yellen would ignore a severe bout of financial turmoil. The breaking point is when financial conditions begin to change the central bank’s forecast.
“The put is there -- it is just further out of the money,” said Michael Gapen, chief U.S. economist at Barclays Capital Inc. As the central bank raises rates, “there could be more volatility and the Fed could be OK with it.”