Three Ways in Which Greenspan Changed Forever the Way Markets Work

The "Maestro" died this week at 100. Mainstream obituaries portray Alan Greenspan in the mode of a “tragic hero” with a distinctly mixed legacy.

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“Alan Greenspan, Fed Chairman Through Prosperity and Crisis. The pre-eminent economic policymaker of his time and a skilled political operator, he favored market-friendly stances that would later come to be associated with destructive financial forces.” – The New York Times

He had been A Great Man – he fronted Time magazine’s “committee to save the world” in 1999, credited with having “prevented a global economic meltdown” – but in the end he was flawed, and compromised – “among those responsible for the 2008 crisis.”

It is a shallow verdict, and a misleading one. Greenspan was philosophically “market-friendly,” but he was hardly responsible for “2008” – for the subprime excesses, Lehman’s collapse, or the rating agencies’ bad calls. He supported stronger capital requirements for the banking industry. He was one of the first (in 2002) to raise the alarm about subprime mortgage lending. He excoriated the rating agencies: “People believe they know what they are doing. And they don’t.” True, he failed to predict the crisis – but so did almost everyone. And although he endorsed some of the financial engineering techniques that later proved unstable, he had little direct regulatory authority with which to rein them in.

And to that point – with respect to the policy levers that he actually did oversee – his record is credible. In the run-up to the crisis, Greenspan’s Fed generally made the appropriate choices where it could. From June of 2004 to July of 2006, as the subprime bubble was inflating, the Fed raised the interest rate 17 times consecutively – a textbook policy of monetary tightening, unprecedented at the time, which should have restrained credit creation. That the crisis happened anyway, despite the Fed’s efforts, makes it clear that Greenspan and the Federal Reserve did not have the tools to avert the catastrophe. (In fact, this was the period when Greenspan famously identified a “conundrum” – the Fed’s short term rate increases failed to drive higher long-term rates, including mortgage rates, which would perhaps have damped down the subprime frenzy. The conundrum exposed the limitations of the Fed’s rate-setting tools.)

Nor should the assessment of Alan Greenspan be based on a catalogue of his opinions, right and wrong, as they appear in hindsight. What matters is what he actually did – how he transformed the Federal Reserve as an institution, in ways that are still very important today. Consider especially the extraordinary impact his policies had in reshaping the financial markets.

Greenspan’s Fed Altered the Capital Markets

The mission of the Federal Reserve – as laid down by Congress in the 1970s – is to manage monetary policy in pursuit of stable prices and full employment, the so-called Dual Mandate. There was no mention of the stock market, and for most of the first 70 years of its existence the Fed paid little or no attention to the great Casino of Wall Street.

Alan Greenspan changed all that. Over the course of his 18 years at the helm, he transformed both the substance and the style of the Fed. He set in motion a process that has created — partly by intent and partly as consequence — an organic link between the Federal Reserve and the capital markets that had not existed before. As a result of his actions, the markets are now hard-locked into the ups and downs of Fed policy deliberations — furiously forecasting, second-guessing, speculating, and hedging the “next Fed move.”

Greenspan’s influence has outlasted his tenure. He created a permanent new role for the Fed Chair as an Icon, “the most powerful person in the world” — and as an Oracle, to whose Delphic comments, gestures, nuances, facial expressions and off-the-cuff remarks the markets are now microscopically attentive.

The effect of Greenspan’s artistry was to alter permanently the way the capital markets function, and to extend the Fed’s influence more deeply into the economy than Congress ever contemplated — and certainly far beyond any Constitutional remit. (There is no mention in the Constitution of a central bank.) The Fed has become an “unelected” Expert Regime, arguably even more powerful than Congress itself. That is Greenspan’s core legacy.

The transformation stems from three Greenspan-inspired shifts in Fed policy.

• Expanded Transparency regarding Fed decisions
• A new way of talking about those decisions, and what might come next
• The de facto augmentation of the Dual Mandate itself – the famous “Greenspan Put”

1. Greenspan’s “Transparency Campaign”

Today, everyone tracks and tries to predict the Fed Funds Rate (FFR: the principal “interest rate” which the Fed manipulates to stimulate or restrain to economy). There are forecasts by outside observers, algorithmic forecasts derived from the prices of Fed Funds Futures (ZQ=F, traded on the CME), and even personal forecasts from the Fed governors (the “Dot Plot”). The market reacts to the release of many major economic indicators first and foremost in terms of the likely impact on the FFR.

A forgotten fact: the Fed never used to announce changes in the interest rate at all. Prior to 1994, rate decisions were made in secret, and rate changes were not even disclosed after the fact. Traders had to guess whether the Fed had modified the FFR based on inferences drawn from prices in the bond market. This policy of secrecy reflected the Fed’s inherited cultural view that rate decisions were technical and internal, and inappropriate for dissemination to stock speculators. Even major policy shifts were debated and implemented without any real publicity. In 1982, for example, the Fed made a structural policy shift to targeting interest rate (rather than the money supply) — arguably one of the most consequential policy decisions of all time — but did not formally announce the change. To this day, academics dispute when exactly the Fed began true rate targeting, with some dating it to the last years of the Volcker Fed and some arguing that it became fully explicit only after Greenspan became the Chairman in 1987. In any case, rate decisions remained secret until 1994, when the Greenspan Fed initiated the current policy of disclosure.

It was a decisive shift. Over the years of Greenspan’s tenure, there was a progressive and radical increase in Fed transparency about its policies and its views.

Greenspan’s policy was continued and extended by his successors. In 2011, Chairman Bernanke initiated the practice of holding press conferences following every meeting of the Federal Reserve Open Market Committee (FOMC), which have developed into something of a media circus. In 2012, the Fed began formal inflation targeting and launched the “dot plot”’ embodying its own high-level rate forecast.

This efflorescence of transparency has had a huge impact on the behavior of the stock market. In 2014, researchers at the Fed documented the astonishing fact that stock market gains were increasingly clustered around the handful of days when the FOMC meetings take place.

“Since 1994, the S&P500 index has on average increased 49 basis points in the 24 hours before scheduled FOMC announcements. These returns do not revert in subsequent trading days and are orders of magnitude larger than those outside the 24-hour pre-FOMC window. As a result, about 80% of annual realized excess stock returns since 1994 are accounted for by the pre-FOMC announcement drift. The statistical significance of the pre-FOMC return is very high.”

(Note the date: 1994, when rate changes first began to be disclosed.)

There is some later evidence that this effect may have lessened since. But for at least twenty years, the “Fed Drift Effect” was pronounced. It occurred regardless of whether rates were raised, lowered or unchanged.

The FOMC meeting is a critical, high-value “event” and traders swarm it. The stock market has become more strongly coupled to the Fed. It also turned many of the normal economic indicators upside down. A strong jobs report, for example, is now seen through the lens of the effect on the Fed’s thinking about interest rates. A sign of economic strength is taken to mean that the Fed is less likely to provide monetary stimulus — and so good news becomes bad news (“Businesses are hiring a little too much for Wall Street’s liking”) and the markets sell off on what should be a cause for economic celebration.

It is hard not to see these developments as distortions of normal market functioning.

2. Greenspan’s Invention of Fedspeak

“‘Fed-speak’ — You learn to mumble with great incoherence.” – Alan Greenspan

Greenspan didn’t just make policy. He talked about it, at length, explaining, entertaining, interpreting some complexities and creating other complexities, in public performances (often in his day these were Congressional hearings) which became signal events of great interest to the financial world. And he invented a new language.

“Fedspeak (also known as Greenspeak) is what has been called ‘a turgid dialect of English’ used by Federal Reserve Board chairs in making wordy, vague, and ambiguous statements. The strategy, which was used most prominently by Alan Greenspan, was used to prevent financial markets from overreacting to the chairman's remarks.”

The dictionaries of Fedspeak include this classic, from Senate testimony:

“Since becoming a central banker, I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”

But to dwell on the humor is to miss the point. Greenspan was creating a new kind of voice for the Federal Reserve. The effect of what he called “constructive ambiguity” was paradoxical, heightening the importance of the Fed Chair’s gnomic utterances. The market began to pay close attention to stray words and nuances. Academic studies find that the “speeches by the Fed Chair are even more important than FOMC announcements for stock prices, Treasury yields, and all but the shortest-maturity interest rate futures.”

Fedspeak, and the market’s obsession to decode it, is now a permanent and (I think) unhealthy aspect of the Fed-Market connection. In 2013, in an off-the-cuff response to a question at a Congressional hearing about Fed bond buying policy (quantitative easing), Ben Bernanke said that “If we see continued improvement, and we have confidence that it is going to be sustained, in the next few meetings we could take a step down in our pace of asset purchases.” This tiny misstep, bland as it was — suggesting that the flood of QE might slow down a little – crushed the bond market for a season or two, the infamous “taper tantrum.” In 2014, the “Yellen gaffe” occurred when a reporter asked how long after the end of QE it might be before the Fed would start raising rates. Janet Yellen — then new at her job and not yet fluent in the new language — made the cardinal error of explicitly translating Fedspeak into ordinary English:

“So, the language that we use in the statement is ‘considerable’ period. So, I — you know, this is the kind of term — it’s hard to define. But, you know, it probably means something on the order of around six months or that type of thing.”

The tenure of Jerome Powell was marked by a number of similar incidents.

Powell’s off-script words during press conferences about interest rate hikes frequently rock financial markets, usually pushing in the opposite direction as the Fed policy committee’s official statements, and causing much more volatility than previous Fed chairs Janet Yellen and Ben Bernanke.

Here’s an example:

The root of this dysfunction goes back to Greenspan and his studied incoherence. Not everyone can do it as well, but the market’s expectations are now highly strung, and unforgiving. Incoming Fed Chair Kevin Warsh has indicated that such detailed Fed commentary will be scaled back. But the market’s tendency to parse imprecise (or overly precise) verbiage for hidden signals may not be easily extinguished.

3. The Greenspan Put

Two months into Greenspan’s first term as Fed Chair, the stock market experienced its worst ever single-day decline. On October 19, 1987, the Dow dropped more than 22%.

Greenspan’s response “defined his legacy.” He quickly announced that the Federal Reserve “affirms today its readiness to serve as a source of liquidity to support the economic and financial system” – and orchestrated a 50 basis point reduction in the Fed Funds Rate. Two more reductions followed in short order. Never before had the Federal Reserve directly and explicitly adjusted the interest rate in response to events in the stock market.

“Source of liquidity” is code for supporting the buy-side of the market, to counter the sell-off. This policy became known as the Greenspan Put (borrowing a term from the options market, where a put is a contract designed to limit losses). It meant that the Fed could be expected henceforward to step in when the stock market got into trouble.

The Put is the most influential and lasting component of Greenspan’s legacy. Under Ben Bernanke, the tool-kit for the Put expanded way beyond setting interest rates. Quantitative Easing (QE) — the huge bond buying program carried out by the Fed after 2008 and continues to this day — was a metastatic version of the Put, working across all segments of the capital markets. QE explicitly aimed at driving up bond prices by swamping the Treasury market with trillions of dollars of price-insensitive buying by the Fed. It also boosted the stock market by reducing bond yields relative to stocks, encouraging investors to shift into equities. Higher stock prices created the so-called wealth effect (“when asset values are high, consumers feel wealthy and go shopping”). In other words, pumping up the stock market was seen as a way to drive consumer spending. The Put became not just downside protection, but an active channel for stimulating the economy. By 2013, the New Yorker m agazine could ask: “The Bernanke Put: Can the market and the economy live without it?”

In effect, the Put expands the Dual Mandate, adding a new dimension to the Fed’s mission. It lacks Congressional sanction, and Fed officials often deny that it exists — but academic studies have found that “textual analysis of the FOMC documents reveals that policymakers do pay attention to the stock market, and their negative stock-market mentions predict federal funds rate cuts.” The noted hedge fund manager David Einhorn described a telling incident in a 2010 interview with Charlie Rose.

David Einhorn: It sometimes feels that the Federal Reserve is more concerned about which way the next 50 points in the S&P go than your average hedge fund manager is….

Charlie Rose: When did you figure that out?

David Einhorn: It was on the Martin Luther King holiday in 2008, which no one will remember, but the markets in the United States were closed and the markets in Europe were open. And over that holiday weekend on Monday the European markets fell an enormous percentage. And the U.S. futures market was indicating that the market would be down a lot. And it looked like there must be some huge problem going on in the world. And the Federal Reserve called an emergency meeting and they lowered the interest rates by three quarters of a percent before the market opened on Tuesday morning. So the U.S. market never even opened at the lower level because they saw the support --

Charlie Rose: So, the Federal Reserve was concerned about what the market reaction may be in the United States.

David Einhorn: The question is, what was going on that caused a need to provide this help to the system? And it later emerged that the Fed didn’t really know what the problem was. They simply saw that the markets were down a lot and within a week it came out that there had been a rogue trader at a large French bank that had taken on some enormous position. And the French bank, when they discovered this, decided they weren’t going to unwind this in some orderly fashion, but they were going to dump a huge amount of equities to unwind this fellow's positions on a Monday of a holiday weekend, which had a disproportionate effect. And it seemed to me if the Federal Reserve was willing to cut interest rates 75 basis points because some French bank was unwinding a proprietary position when nobody was around, I knew that that was what really their primary focus was.

Summary

Alan Greenspan changed the Federal Reserve for good — but perhaps not always for the better. This caveat applies particularly to his impact on the way the financial markets work.

The Transparency Campaign led markets to fixate on Fed policy events, with a significant clustering of market returns in narrow time windows anchored to FOMC meetings. Economic news came to be seen through the lens of its effect on Fed policy, which has created the “good news is bad news” syndrome that often defies economic and common sense.

The emergence of Fedspeak resulted in the growing hypersensitivity of investors to minor nuances (gaffes) in the communications process, with increased volatility and a tendency to jumpiness and disproportionate market moves (e.g., the “taper tantrum”) — not the model of a healthy market.

And the formalization of the Greenspan Put into an active and explicit role for the Fed in “stabilizing” capital markets by stimulating the buy-side — has locked the Fed and the markets in a dysfunctional marriage. It now appears that extracting the Fed from this relationship — by ending QE, for example — may be almost impossible.

By George Calhoun, Contributor