The term Bernanke put has become almost as ubiquitous as the Greenspan put was during the late-1980s and 1990s. Derived from the concept of a put option, these terms refer to central bank policies that encourage risk-taking and force equities higher. For instance, Alan Greenspan was known for lowering the Fed Funds rate whenever the stock market dropped below a certain value, which resulted in a negative yield and encouraged movement into equities.
In these situations, investors have been given a put option of sorts by central banks, since they have a price floor in place. For example, an investor holding 100 shares of a broad market index may have a sort of guarantee from the central bank that the stock won’t drop below 20%, since if it did, the central bank would intervene with low interest rates to boost equity valuations. In this article, we’ll explore these central bank puts in greater detail for investors.
How Central Bank Puts Work
Central banks have a number of different tools at their disposal designed to influence interest rates and thereby impact asset prices. Since the 2008 economic crisis, this toolset has expanded to include options designed to directly influence asset prices. For example, the U.S. Federal Reserve began directly purchasing mortgages and Treasuries during the economic downturn in order to boost the prices and liquidity of these assets during times of trouble.
The most common tools used in monetary policy include:
- Money Supply. Central banks can purchase government bonds in order to increase the money supply or sell them to reduce the money supply in what are known as open market operations. Changes in money supply in turn affect interbank interest rates.
- Interest Rates. Central banks can directly set interest rates, such as the U.S. overnight bank lending rate, in order to control the demand for money. Higher interest rates generally equate to less demand and vice versa for lower interest rates.
- Bank Reserves. Central banks can mandate the amount of money that commercial banks must hold as reserves, thereby influencing the money supply in an indirect way. Higher reserve ratios reduce money supply and vice versa for low reserve ratios.
- Quantitative Easing. Central banks have increasingly resorted to directly purchasing certain assets in order to increase the monetary base and restore liquidity to otherwise illiquid markets, such as the market for mortgages in the U.S. in 2008 and 2009.
Moral Hazards & Other Issues
Central banks have historically been tasked with controlling inflation by influencing interest rates via open market operations. But lately, many central banks have expanded their mandates to focus instead of economic growth, employment, and financial stability. The result since the 2008 economic crisis has been chronically low interest rates designed to stimulate economic growth and improve employment rates within many countries around the world.
The problem is that these mandates may conflict with each other at times. For example, low interest rates have caused a debt bubble in many countries, since companies and consumers are encouraged to take on more debt. Flooding the market with cheap cash could also become a problem when economic growth returns, since the excess capital could quickly lead to inflation unless it’s properly handled by raising interest rates in a timely fashion.
Central bank puts can also become a moral hazard, since market participants will take on greater risks knowing the banks will incur the associated costs. For example, if a central bank implements monetary policy every time the market falls 15%, investors in the market may be willing to take on greater risk knowing that they will likely be rescued by monetary policy. And ultimately, these problems can cause instability within a marketplace.