Author: Vedran Obućina

Analyst, journalist specializing in the Western Balkans and Middle East domestic and foreign affairs

How much is the central bank’s guarantee worth?

During 2019, there was a significant change in the monetary policy of central banks in the United States and the Eurozone. As monetary policy strongly influences economic developments, this has caused a significant change in the short-term macroeconomic outlook.
How much is the central bank's guarantee worth?

Fed headquarters, Washington DC, USA (©PAP)

The US Federal Reserve (Fed) gradually raised interest rates until December 2018, and then stopped. Moreover, in July 2019, after a “break” of several months, the FED lowered its key interest rate and did it again in September and October. The Fed’s leadership justified the change in its monetary policy by the negative phenomena in the world that threatened the American economy. These are primarily the slowdown in economic growth in the Eurozone and the US trade conflict with China. Besides, the change was probably contributed to by the pressure of the US President Donald Trump, who repeatedly expressed dissatisfaction with the monetary policy of the central bank and its leader Jerome Powell.

As for the European Central Bank (ECB), it gradually withdrew the measure of „quantitative easing”, namely the purchase of medium-term and long-term bonds, ending at the end of 2018. In 2019, however, it announced the reintroduction of the same measure, albeit on a smaller scale. in September 2019, it eventually decided, along with easing the conditions for granting targeted long-term loans to commercial banks, and introduced an even more negative interest rate on their excess reserves deposited with the central bank. The leadership of the ECB pointed to the slowdown in economic growth and subdued inflationary pressures as the main reasons for the change in monetary policy. It should be added that the change in policy was probably due to the personal courage of the then President of the European Central Bank Mario Draghi, specifically his willingness to ignore the leaders of the German, Austrian and Dutch central banks who opposed this change together with the German member of the Executive Board. So he eventually resigned. Such behavior has been sharply condemned by some German experts and former officials.

In the US, the economic growth slowed down in 2019 due to the effects of the aforementioned restrictive monetary policy from 2018, and the gradual weakening of the stimulus effects of expansionary fiscal policy. The growth rate of real GDP decreased from 2.9 per cent in 2018 to 2.1 per cent in the Q3’19. Also, there was a distortion of the yield curve, which means that interest rates on short-term loans became higher than interest rates on long-term loans. It is an abnormal phenomenon that has regularly heralded a recession in the past. The distortion, however, was relatively “shallow” and short-lived, which was undoubtedly due to the FED’s new monetary policy.

Little bit of history

But we should turn to a bit of history, as monetary policies of FED’s leaders influences the trust in guarantees central banks offer. Term “Put” coined in the early 1990s, initially seemed like a catchphrase for the media, a simple play on words that would evoke a market-friendly relationship with the central bank. At that time, probably few people expected that a nice word game would come into use decades later, in several different versions. The first was the Greenspan Put, a clear allusion to the central bank’s willingness to lend a firm foothold to Wall Street through an expansive monetary policy. Although Alan Greenspan called the illusion an illusion, many will label him as the key culprit of the epic-scale bubble that burst in early 2000. There is no doubt that the dot-com bubble is largely the result of an extremely stimulating monetary policy that first halted the erosion of Wall Street stock index values and then spurred widespread yield hunting.

„Put”, of course, in this compound refers to the put option, a tool that gives investors the right to sell a particular financial instrument at a predefined price. More sophisticated equity investors often use the option as a kind of collateral to protect themselves from a dramatic drop in prices, and the widespread impression that the central bank operates on a similar principle, protecting the capital market from intense adjustments, has spawned the motto. In the case of Alan Greenspan, historical events have justified the existence of the term, since in 1998 he coordinated the rescue operation of the hedge fund Long Term Capital Management, which threatened to start a chain reaction and panic sale. Finally, the stimulus monetary policy pursued by Greenspan sowed the seeds of the Great Recession, enabling real estate gambling. During the financial crisis, his successor, Ben Bernanke, did not have much choice but to stop the collapse of the financial system through direct intervention. Several rounds of quantitative easing, and then a retreat following the negative market reactions that followed the announcement of the gradual sterilization of interventions (an episode known as „taper tantrum”), also made Bernanke Put a meaningful term.

Janet Yellen followed the same course of a radical departure from the dogmas that limited central bank operations within the rather narrow sphere of key interest rates. The concept of a zero interest rate policy was already a significant departure from orthodox monetary policy, and direct interventions in financial markets (and the unstoppable growth of the central bank’s balance sheet), which included not only government bonds but also the purchase of shares and corporate bonds. The range of available monetary policy instruments have been further expanded. All of this was inherited by Jerome Powell, under whose leadership the Fed provided a very firm foothold to Wall Street even before the coronavirus pandemic broke out, in part because of White House pressure. If there was any gap towards unconventional monetary policy measures, it disappeared completely in the pandemic. Almost overnight, the central bank shifted from the usual role of „bank of all banks” (the correct term would be „lender of the last resort”) into a superior market maker who, without any discrimination, operated in various segments of financial markets. In addition, Mr. Powell has made it clear that fears of potential bubbles in the market, at least from the Fed perspective, are currently in the background.

Fed’s impact

A brief recapitulation of these lines from history confirms that the Fed has served as fairly reliable support for investors in recent decades, to the extent that this central bank is labelled by some observers as a very potent weapon in the context of market psychology and crammed into central bank tools. But what exactly is the impact of the Fed and can it be quantified more accurately? The group of authors of a research „Moral Hazard and the US Stock Market: Analyzing the Greenspan Put” concluded that behind the intense stock market valuations is not only the „irrational optimism” of investors but also the perception of the central bank as a factor stabilizing the market. The indirect influence of the central bank on stock price movements was also measured by authors of a study simply called „The Greenspan Put”, using option put prices as a means of quantifying the Fed’s impact. The results show that out of the moneyput options (a means of securing a dramatic decline) are cheaper at a time when investors are discovering active Fed support, while out of the moneycall options, which offer the possibility of betting intense stock price growth, are more expensive – and more sought after. Thus, in the eyes of investors also a more likely scenario. The phenomenon described is of lesser intensity after the Great Recession, but this is probably largely due to a truly dramatic decline in the value of stock indices that the Fed has failed to prevent. There is another interesting research „From Free Markets to FED Markets: How Unconventional Monetary Policy Distorts Equity Markets.” This is a study by Talis Putnins, published in June 2020, focusing on figures from the central bank’s balance sheet. For a start, it is difficult not to notice the connection between monetary policy and events on Wall Street, first through the ratio of interest rates (Fed funds rate) and the performance of the S&P 500 index, and then through fluctuations in Fed assets.

The weaker correlation between interest rates and indices after the Great Recession is a logical consequence of record-low interest rates; as the Fed is still wary of negative interest rates and the exchange rate persistently pursued by the ECB, the purchase of securities (primarily government bonds) has become a key monetary policy instrument, and the Fed’s booming assets are a major measure of market impact.

In February and March 2020, Fed started implementing the buyout program for practically everything, and one can also notice the positive feedbacks of Wall Street, with which the S&P 500 finally gained positive territory. But Mr. Putnins went a step further in his analysis for the period from January 2009, immediately after the implementation of the QE program, to mid-May 2020. First, he found a negative correlation between the movement of the S&P 500 index and the size of Fed assets, namely with a certain time lag. Or in simple words — a significant decline in the value of the S&P 500 index usually a month later increases central bank assets, after which the correlation takes a positive sign (the index grows in parallel with the assets). The strong relationship is confirmed by the Fed’s positive response (increase in assets) to a 10 per cent drop in the S&P 500 index, and in the index’s movement after a 10 per cent increase in Fed’s assets.

Central banks and stock exchanges

The author speaks precisely about the symbiotic relationship between monetary authorities and Wall Street; a double-digit decline in the index results in an increase in assets of 6.7 per cent on average, while an increase in assets of 10 per cent results in an average increase in the value of the index of 7.4 per cent (over the next five to eight weeks). Perhaps more importantly, this relationship is characterized by an evident asymmetry — central bank reactions are much more vigorous in the face of a negative trend on Wall Street, while on the other hand, the market reacts more quickly to asset contractions.

Monetary policymakers, who refuse to follow in the footsteps of their Japanese counterparts, are probably aware of this. Namely, the Japanese central bank does not hesitate to buy shares (through ETFs), while in the case of the Fed, this mechanism, at least for now, is firmly within the theoretical possibilities. No wonder, because the already positive effect of the purchase of debt securities (both government and corporate) is largely spilt over into the stock market.

Mr. Putnins states that between a quarter and a half of the growth of the S&P 500 index can be attributed to Fed interventions in March 2020, and this then explains the evident gap between capital market performance and truly desperate macroeconomic variables.

The first episode of the story about the role of the central bank in the financial markets, better known as the Greenspan Put, ended in tears, but after that things went very well for investors. All of this has an impact on the EU economy as well. Production is also affected by external demand, especially by the US as the European Union’s largest trading partner. It is unlikely that the value of US imports of European products will continue to increase at a rate of 11 per cent, as was the case in the first ten months of 2019. Besides, the US President is threatening to raise tariffs on European products. As for other trading partners, China should not be counted on not only because of the conflict with the US, but also because it discourages net imports through financial investments abroad that create pressures in the direction of depreciation (weakening) of its currency. Ultimately, the UK’s exit from the European Union will certainly have a negative foreign trade effect, especially if a favorable agreement is not reached. Due to all this, one should not expect a large contribution of exports to economic growth.

The implicit guarantee of the central bank is undoubtedly an important component of this success.By the end of 2018, the central banks of America and the Eurozone “stopped”, before their restrictive policies reached proportions that would have severe economic consequences. Moreover, during the H2’19, they switched to a policy of the opposite direction. Therefore, the economies of Western countries in 2020 will be marked by a low rate of economic growth, with a slight and short-lived recession in some places, but it is almost certain that there will be no deep economic crisis. The only question is until when? Inflation has not been a problem for years, but this practice cannot be extended indefinitely, especially after the coronavirus vaccine would be widely used. This means that over the next year, the idea of a more significant reduction in the balance sheet and sterilization of market interventions could begin to creep into the minds of monetary policymakers, which could be the end of intense financial repression.

Fed headquarters, Washington DC, USA (©PAP)


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