Week in Review: Whatever happened to the Greenspan Put?

Last week was relatively uneventful on the banking crisis front, as investors are judging that the crisis is over. The Fed Funds futures are becoming slightly more hawkish but they still indicate we are in the bottom of the 9th when it comes to further rate hikes.

We had some good news on the inflation front last week, with the PCE Price Index falling to a monthly increase of 0.3% after rising 0.6% in January. It looks like the spike in January was short-lived, or perhaps a statistical artifact. Academics have noted consistent biases in GDP data in the first quarter (usually too low), and perhaps the January print was a similar effect. The annualized inflation numbers are still declining, with year-over-year inflation falling to 5%. Real Estate is probably playing a part here. It looks like real estate prices peaked in June of 2022, at least according to Case-Shiller, which means year-over-year comparisons will start turning negative before long. This will go a long way towards reducing the inflation numbers, although the strength of the job market remains the Fed’s biggest concern.

The University of Michigan Consumer Confidence numbers showed a decrease in inflationary expectations, which was good news. Consumers expected inflation to come in around 3.6% over the next year. This is a pretty significant drop from the 4.1% they were expecting in February. The worry for the Fed is elevated inflationary expectations in the context of a tight labor market. If inflationary expectations get tied in with wage negotiations, inflation becomes a much more intractable problem.

Given the problems with Silicon Valley Bank and Signature bank, whatever happened to the Greenspan Put? The Greenspan Put basically meant that in the event of financial instability, the Fed would intervene and start cutting rates. A “put” is an options contract that puts a floor under the price of a security. If you owned Tesla stock, and had a put with it, that put says if you sell Tesla you will get no less than the strike price on the options contract.

In the context of the financial markets and the economy, the Greenspan Put was the perception that then Fed Chairman Alan Greenspan would ride to the rescue in the event of financial instability. It came out of the Crash of 1987 when Alan Greenspan assured the markets that the Fed would stand by to provide liquidity (i.e. loan money) as needed. This move was credited with saving the day after the crash.

During the 1990s, we saw the Fed cut rates during the Asian currency crisis, and the Fed rode to the rescue after the stock market bubble burst, and again after the US residential real estate bubble burst. It became a matter of faith that if things got ugly in terms of financial pain, the Fed would cut rates.

I think part of the explanation for the Greenspan Put was the dual mandate, which tells the Fed it must control inflation and stimulate employment. Back in the 1970s, Congress was concerned that the central bank was focusing too much on lowering inflation, and not enough on minimizing unemployment. Stagflation was a thing back then, where we had strong inflation in the context of limited growth. The idea was that labor should not be the sacrificial lamb for capital. The dual mandate was well-meaning, however the unintended consequences have been a series of financial bubbles.

In practice, the dual mandate has meant that the Fed must push down rates as long as inflation (measured by the CPI or PCE index) was under control and we were below full employment. During the 80s and 90s, cheap goods from Asia managed to keep inflation at the consumer level in check. The collapse of the Japanese stock and real estate markets meant the country was exporting deflation. At the same time, the US below full employment, so the Fed had a built-in excuse to push rates lower.

However all that cheap money had to go somewhere, and it went into financial assets. Instead of “too much money chasing too few goods” we had a situation of “too much money chasing too few assets.” Since the dual mandate was instituted, we have seen bubbles in commodities (late 70s), stocks (late 90s) and residential real estate (mid-00s). In fact, you could argue that we are in the midst of a sovereign debt bubble now, with inflation-adjusted sovereign yields still negative.

Bubble psychology means that investors believe an asset is “special” and can only go up in price over time. We saw that mentality in the 90s with stocks: “Just buy quality companies and don’t worry about valuation. So what if you are paying 70 times earnings for Cisco Systems, the Internet is not going anywhere!” We saw it with residential real estate in the 00s - “They aren’t making more land, buy rights to a condo in the new Trump building.” (yes those were a thing). And in the case of sovereign debt, you had Silicon Valley Bank lose money in Treasuries, as it bet that the Fed would start cutting rates.

Bubbles aren’t a strictly American phenomenon - At one point the Tokyo Imperial Palace grounds was worth more than all the real estate in California. China certainly has a property bubble as well, with entire cities being built on spec. But the United States seems to have had a lot of them going back to the 1970s, and the Fed’s mentality has shifted pretty dramatically from the days of 1950s Fed Chairman William McChesney who quipped “The role of the Fed is to take away the punch bowl just as the party is getting going.” Over the past 40 years, the mantra has been more along the likes of “Keep the pedal to the metal as long as the CPI is behaving.” Perhaps things are changing.

The collapse of Silicon Valley Bank was a test to see if the Greenspan Put still exists. So far, it looks like the Fed doesn’t think so.