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JUNE 21, 2013
THE BERNANKE PUT: CAN THE MARKETS AND THE ECONOMY LIVE WITHOUT IT?
POSTED BY JOHN CASSIDY

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In finance, a “put” is a contract that gives its owner the right to sell something—a stock, a bond, a tanker of crude oil—at certain price, regardless of the price in the market. A put is a guarantee, basically, and when the markets are falling it can be invaluable. But the word is sometimes used in a more general sense.

Back in the old days, when Mark Zuckerberg was in high school and Alan Greenspan was in Foggy Bottom, there was something called “the Greenspan put.” It was a commitment on the part of the Fed to cut interest rates and print money whenever the markets or the economy stumbled. Although its existence was officially denied, many investors believed it was in place, and this belief helped sustain the great stock market bubble of the late nineteen-nineties.

For the past few years, the Fed has been issuing another type of official guarantee, this time in the bond market. Call it “the Bernanke put.” In reducing the short-term interest rate it controls practically to zero, and committing to purchase trillions of dollars of Treasury bonds and high-grade mortgage bonds—a tactic known as quantitative easing—the Fed has managed to bring mortgage rates, and other lending rates, down to levels not seen since the nineteen-fifties. Just as it was designed to do, this policy has given a significant boost to the housing market, and to other parts of the economy, but its flip side has been a bubble, or something closely resembling a bubble, in the global bond markets.

With investors chasing anything with a decent yield, they’ve piled into lower quality bonds—such as “junk bonds” issued by companies with poor credit ratings, and debts issued by governments in emerging markets—greatly narrowing the interest-rate premiums that such securities normally carry. As long as the Fed remained committed to quantitative easing, the risks that investors faced in buying these types of bonds, or any other risky financial asset, was greatly attenuated. Whilst much of the action was in the bond markets, quantitative easing also gave a boost to stock prices, which have more than doubled in the past four years.

Over all, the Fed’s policy has been reasonably successful. As I’ve been saying for months, and as Bernanke confirmed earlier this week, the economic recovery is gradually strengthening. That’s why the Fed chairman decided this was the right time to prepare the markets for a change in policy. In theory, Bernanke’s gambit was a perfectly reasonable one. Quantitative easing was always meant to be an emergency measure, not a permanent fixture. But the market’s panicked reaction illustrates just how difficult it is for the Fed to remove a put it has previously issued, or is widely perceived to have issued.

Expressed bluntly, a Fed chairman intent on forcing the economy to stand on its own two feet has to be willing to accept some turmoil in the markets, and some collateral damage to the economy itself. A modest fall in stock prices, which is what we’ve seen in the past few days, is the least of it. Mortgage rates have already started to rise toward more normal levels, and the wave of cheap refinancings may be coming to an end. That will put a crimp on the housing market and on consumer spending. Combined with the impact of the sequester, which is still to be fully felt, these things could put a damper on G.D.P. growth in the second half of this year, when the Fed is expecting it to accelerate. And, meanwhile, as the bond-market bubble starts to deflate, there’s a danger of some big financial institution that has been overexposed getting into trouble.

Bernanke, his colleagues, and his successor—his term is up next January—will have to withstand all of this. In addition, they will come under attack from commentators and politicians who believe that, with the unemployment rate still very high and the rate of inflation still very low, they shouldn’t be doing anything to tighten policy. Even some Fed insiders take this view. In a statement released on Friday, James Bullard, the head of the Federal Reserve Bank of St. Louis and a colleague of Bernanke on the Federal Open Market Committee, said the announcement of the plan to draw down quantitative easing was “inappropriately timed,” and should have been delayed until there was more confirmed evidence of a pickup in economic growth.

I have some sympathy for Bullard’s argument, but also for the predicament in which Bernanke finds himself. When Greenspan was the Fed chairman, one of the major criticisms about his policies was that they encouraged investors to believe that the central bank would always be there to protect them, and thereby contributed to excessive risk-taking—a phenomenon known as “moral hazard.” (I made this argument myself, at book length.) By issuing a warning now that quantitative easing may be coming to an end, Bernanke is seeking to forestall this problem before it generates another boom-bust cycle. But being a tough cop is never easy.

Photograph by Mandel Ngan/AFP/Getty.

KEYWORDS BEN BERNANKE; FEDERAL RESERVE; BUSINESS; FINANCE