Friday, August 17, 2007

To Put or Not To Put

Pardon my language, but enough with the God damn Greenspan put! There never was a Greenspan put!

Let me be more precise. There was, and is (and ever more shall be, if the Fed does its job well), a put on the general price level. So if you’re speculating directly on the general price level, you can expect some degree of protection from the Fed. For example, if you buy TIPS and short nominal Treasury notes, and if you maintain enough capital to meet a reasonable range of margin calls, Ben Bernanke will make sure you don’t go broke. (He will also try his damnedest to make sure you don’t make any money out of the deal either, but that’s another story.) If you are following this strategy, consider yourself protected. If your enemies are following this strategy, and it pisses you off that they are being protected by the Fed, go ahead and send hate mail to Ben Bernanke. He welcomes your hatred. (Not that I have inside information on this point; it’s just that any reasonable central banker should welcome the hatred of those who think deflation is acceptable.)

The impression that there is a put on certain other assets arises from the fact that various assets are correlated with the general price level in complicated ways. So if you bought stock during 1998, when the general price level in the US was fairly stable and there were deflationary forces afoot in the world, you could be confident that Greenspan would bale you out. You have to recognize, though, that when he bails you out, it doesn’t mean he likes you. It just means he dislikes deflation. On the other hand, if you bought stock during early 2000, when the inflation rate was showing signs of acceleration, you couldn’t count on Greenspan to protect you. Those who did somehow found themselves unable to exercise that protective put that they thought they owned.

In retrospect, it seems clear that the Fed reacted too quickly and too aggressively in 1998, and not quickly enough in 2000-2001. Ben Bernanke has the benefit of hindsight on both of those episodes, and he will presumably try to steer and intermediate path. A lot of people (more than in 1998, one might imagine) will end up bankrupt, and certain pundits will watch them and curse the Fed for risking a meltdown. A lot of people (more than in 2001-2002, one might hope) will find that their perhaps ill-advised investments recover enough to avoid bankruptcy, and certain pundits will watch them and curse the Fed for encouraging inappropriate risk-taking. And those who make their living by writing straddles on general price indexes (if there are any such people) will, in all likelihood, keep on happily collecting premiums as if nothing were happening.

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Anonymous Anonymous said...


I like your (too infrequent) posts, and we all have our quirks, but really, this topic is beneath your considerable intellectual prowess.

Maybe I have hung around with trading sorts too long, and they have considerable affinity for colorful language, but the use of the term "Greenspan put" doesn't offend me. It says in a crude but largely accurately way that when things got messy in the securities markets, Uncle Al would intervene sufficiently aggressively so as to create a floor.

Remember too that Greenspan was obsessed with the stock market (not particular stocks, but the general level, see the May 8, 2000 edition of the WSJ for details). That's not and never was the Fed's job.

Fri Aug 17, 04:09:00 PM EDT  
Blogger knzn said...

anon: “Uncle Al would intervene sufficiently aggressively so as to create a floor.”

If there was a Greenspan put on the S&P500 in 2000-2003, the strike price was so low as to make it almost irrelevant. Of course Greenspan took the stock market into account, because the stock market is an excellent leading indicator. Any central banker who wasn’t concerned with the stock market would not be following the mandate of seeking price stability and maximum employment.

People who have tried econometrically to find an empirical meaning for the Greenspan put have failed. (See Brad DeLong’s post to which I linked.) Of course, if things get so messy as to threaten deflation or a non-inflationary recession, a competent central banker will react. That is not a bailout; it’s just good monetary policy.

Fri Aug 17, 04:43:00 PM EDT  
Blogger knzn said...

I won’t necessarily object to the use of the term “Greenspan put,” since, as I say in the post, there is a put on the general price level (and sort of on employment, but it’s hard to express how that one works), and the values of financial assets are correlated with the general price level (and with employment, and moreover the correlation usually involves a lag on asset prices, making them leading indicators of what the central bank is trying to control). But I object to the view that Fed policy under Greenspan created inappropriate moral hazard. There are some risks that don’t exist – or that are minimized – when monetary policy is well executed. If investors have confidence in monetary policy, they should act in the expectation that those risks will be minimal. That’s not moral hazard; it’s just a reasonable set of rules to live under.

Fri Aug 17, 05:05:00 PM EDT  
Anonymous Anonymous said...

"Even a fool learns something once it hits him." -- Menelaus, Iliad (at least I think I catch the book referring to "KNZN"...)

2 points:

1. I believe investors who write straddles on the general price level are effectively short interest volatility, if you believe that interest rates reflect the real rate plus inflation expectations. Investors holding mortgage-backed securities and callable securities are such a group that is short rate vol.

2. Your attempted distinction between "Fed actions that benefit you" and "whether the Fed says it likes you" based on investment strategy is not very useful. Investors rightly care most about actions, not words. Too many investors, politicians, corporate managers say one thing and do another, or talk their own book.

Sat Aug 18, 12:10:00 AM EDT  
Blogger knzn said...

Responding to the 2 points:

1. I think it’s important to separate the real rate component from the inflation component. In the years since TIPS have been trading, the greater part of the volatility in nominal interest rates has been in the real rate component. (If you look at actual TIPS during the first few years, there were large fluctuations in the liquidity premium, but if you look at survey evidence, long-term inflation expectations have been very stable during this whole period.) So being short nominal interest rate volatility, you would be speculating mostly on real rate volatility. I won’t opine on whether and when that’s a good bet. However, if you hedge out the real rate just go short the volatility of expected inflation, it is a very good bet as long as the people have confidence in the Fed.

2. I wasn’t referring to “whether the Fed says it likes you.” What I meant was that, when the Fed protects investors, it doesn’t do so for the benefit of those investors but for the benefit of the general public. Obviously those investors do benefit, but that’s a side effect, and it’s ultimately not a reliable side effect, as the stock market experience during 2001 and 2002 makes clear.

Sat Aug 18, 02:17:00 AM EDT  
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