Why the Fed will not step in if asset prices correct

Greenspan put is a generic name given to all the policies that the former Fed Reserve Chairman Alan Greenspan implemented to prop up the market whenever it began to decline.

Koo explained why no backstopping will come from the Fed. This time, the US banking system is flush with reserves, he said. The reserves total $3.6 trillion, which is many times more than what it was when the Lehman Brothers collapsed after the 2008 subprime crisis, he said.

“If the only way monetary tightening can work in such a situation is through determined QT (quantitative tightening) lowering asset prices, then markets should not rely on ‘central bank put’ until inflation is no longer an issue,” he said in the presentation. 

In an earlier interview with Moneycontrol, MPC member Prof Jayanth R Varma too had said that the Greenspan put might be a thing of the past. “When push comes to shove, the Fed might say that our primary mandate is to contain inflation and not to prop up equity markets. I get a sense that the Greenspan put is past its expiry date,” Varma had said. 

Reason behind reserves

At the investor forum, Koo presented data that showed that all through the quantitative easing done by the Fed, from 2008 to 2022, the borrowings hardly moved. Over the 14 years, it went up from 100 level to 146. “A 46 percent rise, which is nothing, hardly 4 per cent a year,” he said. 

But now the borrowing is beginning to pick up. It saw a sharp rise in July 2021. If this continues and the ample reserves are released into the real economy through these borrowings, then inflation can go significantly up. “The Fed has something to worry about because demand-driven inflation is back in the picture,” he said.

In other countries too bank lending is beginning to move up. In the Eurozone, over the 14 years, borrowing went up from 100 level to 117 in 2022; in the UK, it went from 100 to 106; and in Japan from 100 to 136.

Meanwhile, asset bubbles are beginning to form. “Some (asset) bubbles are way beyond 2008 levels,” he said through his presentation, saying house prices are up 55% from 2008 and commercial real estate is higher by 68% from then.

In such a situation, when the monetary base can shoot up and asset bubbles are building, the central bank may need to do more than rate hikes. It will need to shrink the monetary base too. “Massive amounts of Fed reserves need to be brought down and interest rates have to be brought up, and two have to happen at the same time. That is the biggest challenge the central bank has faced in a very, very long time,” he said.

While the Fed chairman Jerome Powell has been referencing the former Fed chairman Paul Volcker often these days, saying that the same tools are available with the central bank even today and that inflation can be brought down with them, Koo said that it isn’t true. While during Volcker’s time, banks couldn’t lend heavily because reserves were limited, now banks have access to a large reserve and banks seem to be easing their credit-lending norms due to competitive pressure.

The thing to do is to remove the excess reserve from the system as soon as possible and that has been tried once before in 2017 under the former Fed chair Janet Yellen. If quantitative tightening is done at the pace she had attempted in 2017, it will take another eight years for the monetary base to normalise. “When you have CPI inflation at 8 percent levels, you don’t have that much time,” said Koo. Therefore, Powell’s QT seems to be at double the pace, taking out $95 billion a month, which is “going to be quite a shock to the market”.