Emergency rate cut revives talk of 'Bernanke put'


By Alister Bull
Sunday, January 27, 2008


WASHINGTON -- An emergency U.S. interest rate cut last week rekindled perceptions the Federal Reserve has a bias to protect the stock market, and a French bank trading scandal has made matters worse.

Deep losses in stock markets around the world last Monday spurred the U.S. central bank into making its biggest rate cut in more than 23 years on Tuesday, but the stocks drop came as 144-year-old Societe Generale unwound positions taken by a rogue trader.

"Disclosures that unwinding of rogue trades also contributed to the weekend meltdown have nurtured perceptions that a new 'Bernanke put' has appeared," Morgan Stanley economists Richard Berner and David Greenlaw wrote on Friday, referring to Ben Bernanke, the chairman of the central bank.

The idea of a put reflects concerns that the rate cut shielded investors from a stock sell-off in the same way traders use a "put" option to limit losses on a security.

Former Fed Chairman Alan Greenspan faced long-standing criticism that he pursued a policy of protecting markets, a view that became popular after the central bank cut interest rates sharply in the wake of the collapse of Long Term Capital Management in 1998.

Critics fear that a similar impression of the Bernanke-led Fed could be a costly one to correct, and might mean higher interest rates in the future than would otherwise be required.

The Fed slashed benchmark interest rates by three-quarters of a percentage point to 3.5 percent on Tuesday before the open of U.S. stock markets, which had been closed for a holiday on Monday. At that time, U.S. stock futures were indicating Wall Street would follow overseas markets in a steep plunge.

The emergency rate cut came just a week ahead of a regularly scheduled Fed policy meeting.

Thursday's disclosure that SocGen dumped stock positions on Monday after discovering that a rogue trader had taken on huge positions has intensified criticism of the Fed for using the equity market as a barometer of the wider economy.

"It is good monetary policy to put some distance between interest rate policy actions and market re-pricing," said Marvin Goodfriend, a former senior adviser at the Federal Reserve Bank of Richmond and now an economics professor at Carnegie Mellon University's Tepper Business School.

Bernanke had taken firm steps at the onset of the current market turmoil in August to bury any idea he would bail out investors, and had labored to separate actions to help markets function smoothly from rate moves aimed at the economy.

"It is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions," he told a central bank gathering in Jackson Hole, Wyoming.

"But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy," he added.

Four months later, and 10 percent lower on the Dow, the sentiment in the second part of that statement seems to be guiding the Fed, relegating concerns that policy-makers are bailing out investors to the back-seat.

"They are getting themselves deeper into a hole," warned Robert Eisenbeis, former research boss at the Federal Reserve Bank of Atlanta, who argued that the cumulative 1-3/4 points of Fed easing since August posed a clear moral hazard.

"It makes people believe that there will never be a downside. That housing will never go down," he said.

Other observers saw no ground for claiming that the Fed was saving the stock market, but did see scope for problems down the road if the idea of a Bernanke put took hold and it led markets to expect an easy monetary policy and higher future inflation.

"The Fed really does not want to bail out investors. There is lots of money to be lost, there will be lots more blood on the floor before this is done," said James Hamilton, professor of economics at the University of California at San Diego.

"But if the 'Bernanke put' story becomes widespread and people get the idea that we're going back to five percent inflation, then, one, it's not true, and two, it will require a higher interest rate than otherwise required," he said.

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