KEY POINTS:
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 United States sharemarket has suffered episodes of vertigo - about one a week - usually on news of something foul in the sub-prime
market, after which it goes back to scale new heights.
Last week, something happened. The sharemarket 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 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 past 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. "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 sharemarket 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 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 sharemarket rescue efforts: Greenspan cut the overnight federal funds rate in 1995 after 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 the Fed would cut rates if things got too dicey in the sharemarket, which had become the national pastime in the late 1990s.
Greenspan inherited a 4.2 per cent inflation rate (using the core consumer price index) 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 per cent.
Joe Carson, director of global economic research at AllianceBernstein, said while Greenspan was considered an inflation fighter, in reality he placed more emphasis on achieving maximum sustainable employment than the Fed's other mandate, price stability.
"Greenspan was much more willing [than Bernanke] to move official rates up or down if changes in present or prospective economic conditions were perceived as a threat to the quest for maximum employment [or growth] and ultimately to price stability," he said.
Rather than speed limits for growth or ceilings for inflation, Greenspan "focused instead on the imbalances that would engender economic and price strains".
Core inflation has been above the Fed's comfort zone of 1 to 2 per cent for some time. Bernanke has given no sign 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 per cent in the 12 months to June, down from a peak of 2.9 per cent in September 2006.
Carson said that inflation rate did not pose a hurdle to Greenspan, who cut rates 16 times in the last decade of his tenure with core inflation at 2.2 per cent or higher "because other economic or financial imbalances were more pressing at the time".
Cut to the chase: If Greenspan were Fed chairman, would he be cutting rates now? Probably not, Carson said, but he'd be leaning in that direction. One could imagine him making an elaborate argument that the only reason the core CPI was above 2 per cent was "because CPI housing costs are based on imputed rents, not actual prices".
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 the 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 per cent 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.
- BLOOMBERG
