Dollars and Jens
Tuesday, August 14, 2007
the Greenspan put
There has been a fair amount of talk lately about fed responses to market downturns; indeed, there has been some criticism of a "fed put" or "Greenspan put" whereby the fed stands ready to bail out investors, and thereby creates a moral hazard. (Though it has some cheerleaders. Incidentally, it's entirely acceptable to me that the intricacies of United States monetary policy are decoupled from the whims of Jim Cramer's pharmacist. If you don't know what I'm talking about, never mind.) I'm not sure whether the fed really tries to bail out markets or not, but the main purpose of this post is to insist on the distinction between that concept and the fed's inclusion of the effect of financial downturns on the real economy into its considerations when formulating monetary policy.
While the fed sets a target for — and keeps a pretty good handle on — the interest rate at which big, safe banks lend each other money overnight, the actual ease and expense with which companies making investments (or consumers making purchases) borrow money are determined in the markets. When bond markets and stock markets tumble, that has an impact on the economy; a fed funds target that might have been neutral before, if maintained, will be contractionary when the neutral rate decreases. The fed's job is to maintain the stability of the value of the dollar, and it can't simply ignore major factors that influence how that is to be done; as long as it's targetting an interest rate, it is absolutely affected by financial markets.
Does that — the fact that, in the event of a market downturn, the fed will cut rates — encourage risk-taking in advance? Probably, but not in excess. The optimal amount of risk to take is not the answer to "what would be the optimal amount of risk to take if the Fed kept its head in the sand when the markets dropped?" In an efficient world, in fact, the amount of risk taken optimizes "the optimal amount of risk to take if the Fed responds in exactly the right way to maintain the stability of the currency." If that, in fact, is all the fed is doing, then responding to it is correct; imagining that short-term interest rates are pre-ordained is, in fact, likely to lead to excess caution.
That's not to say the fed should try to bail out investors. If the fed is thinking, "a 25bp cut would restore neutrality, but would still leave investors with big losses, while cutting rates 50bp would be a bit inflationary but would soften the blow to investors," their job is to cut rates 25 bp. A bigger cut, aside from creating the aforementioned moral hazard, sows the seeds of the next cycle of excess. The best thing for the fed to do is to provide a stable currency; if they can keep an even keel while everything else shifts around above deck the economy has a much better chance of reequilibrating in a healthy way than if they keep confusing price signals.
As I noted two weeks ago, this is Bill Poole's take on it as well. This makes it easier for me to sleep well at night.