Wall Street expects the Fed to raise interest rates by a quarter point at its meeting Dec. 13 to 14. But there is a potential surprise: The world may learn that the Fed wants to raise rates aggressively in 2017 and 2018. This new, more “hawkish” monetary policy may become known as the “Yellen Collar.”
On Oct. 20, 1987, the Federal Reserve intervened to prop up the stock market, and the “Greenspan Put” was born. The Greenspan Put is the implicit guarantee that the U.S. Federal Reserve will print massive amounts of money to stop any stock market crash. (A “put” is a side bet in the options market that an asset will drop in value.)
Thirty years later, we are seeing the Yellen Collar, a more sophisticated side bet. Federal Reserve Chair Janet Yellen would like to raise interest rates a dozen times or more. The Yellen Collar is an options term that combines the Greenspan Put with Chair Yellen’s desire to increase interest rates as fast as the stock market allows.
The Greenspan Put: If the stock market crashes, the Fed will bail out investors.
The Yellen Collar: The Greenspan Put plus if stock market goes up, the Fed will raise rates (a lot).
If 2017 is indeed the year of the Yellen Collar, it will be an enormous change in global financial markets. Furthermore, if the Fed is able to significantly raise rates beginning in 2017, it will be, for lack of a more nuanced term, good.
Three decades of the Greenspan Put
Alan Greenspan became chair of the U.S. Federal Reserve on Aug. 11, 1987. Greenspan was interested in the stock market and kept a keen eye on the Dow Jones Industrial Average. During early meetings as Chair of the Federal Reserve, Greenspan was puzzled by the attitude of his colleagues. They did not monitor the stock market and thought their job was to maintain a sound currency.
Just two months after becoming chair, Alan Greenspan witnessed the largest one-day stock market crash in the history of the United States. On Oct. 19, 1987, the Dow Jones Industrial Average lost 22.6 percent of its value. Even before the stock market opened the next morning, the Federal Reserve announced increased monetary stimulus. The Greenspan Put was unveiled in under 24 hours. (I wish all insurance contracts were honored so promptly.)
Born in under a day, the Greenspan Put is flourishing 30 years later. One enormous change since 1987 is that every member of the Federal Reserve now watches the stock market continuously. Any drop in the stock market is quickly greeted with Fed choruses of loose money.
The latest incident began late in 2015. The Federal Reserve raised interest rates in December 2015 and predicted it would raise interest rates four times in 2016. In reaction to the prospect of rising interest rates, the stock market collapsed in January and February.
To stop the stock market decline, the Fed deployed the venerable Greenspan Put. The Fed retreated from their promise of interest rate increases and even hinted at possible monetary easing. The stock market rallied and soon reached new highs.
For 30 years, the Fed has cushioned every stock market decline with loose money.
The wealth effect and the Greenspan Put
Willy Sutton robbed banks because “that’s where the money is.” The Greenspan Put helps people who own stocks, because they have most of the money.
When he was chair of the Federal Reserve, Ben Bernanke made this “wealth effect” argument explicit, by writing in an editorial, “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
Ben Bernanke’s editorial argues that the Fed acts to support the stock market, not because it cares about the stock market directly and not because the Fed wants to make rich people richer, but because it wants spending by rich people to trickle down to the rest of the economy.
Whatever the true motivation of the Fed, we can be sure that future market crashes will cause the Federal Reserve to act to try to save the stock market.
The Greenspan Put is alive and well.
Janet Yellen wants to increase interest rates a lot
The Federal Reserve controls the federal funds rate, a short-term interest rate that affects all aspects of the economy. The federal funds rate currently is 0.25 percent, while the post-World War II average is just over 5 percent, and the peak was almost 20 percent. The Fed has a lot of room to raise interest rates.
Yellen announced her desire to raise interest rates a dozen times or more at the important Jackson Hole conference in August 2016. In her speech, she noted that in response to the most recent nine recessions, “the FOMC [Federal Open Market Committee] cut the federal funds rate by amounts ranging from about 3 percentage points to more than 10 percentage points.”
To understand Yellen’s motivation, consider that it has been seven years since the last U.S. recession ended. Since World War II, recessions have arrived about once every six years. Another recession is coming; the only unknown is the date.
If the next recession were to hit soon, the Fed could not respond by cutting interest rates aggressively. With interest rates still so close to zero, the Fed could cut rates back to zero, and it could unleash more printing of money (more printing is still the outcome that I expect). It could not, however, fight a recession with interest rate cuts alone.
So Yellen wants to raise rates to provide the Fed with ammunition to fight the next recession. Because the Fed has historically cut rates by between 3 and 10 percent, Yellen wonders if raising the federal funds rate to 3 percent is too little. “Would an average federal funds rate of about 3 percent impair the Fed’s ability to fight recessions?” she asked in 2016.
Accordingly, Yellen would like to raise rates a dozen times or more. The Fed needs 11 more quarter-point interest raises to reach 3 percent on the federal funds rate, the low end of the historical range. A dozen interest rate increases would get the Fed to 3.25 percent. Twenty rate increases would give the Fed a cushion of just over 5 percent.
Another recession is coming. When the storm hits, Yellen would like the Fed funds rate to be at least 3 percent. Thus, the Fed would like to raise interest rates significantly.
The Yellen Collar
The concept of the Yellen Collar has existed for several years. If implemented in 2017, it means the Fed will persistently increase interest rates as long as the stock market doesn’t collapse.
The Federal Reserve’s official mandate is to create jobs and maintain stable prices. Its actual mandate under the Yellen Collar is to stabilize the stock market. Stock market rallies will be met with higher interest rates. Any significant stock market decline will be mitigated by the Greenspan Put in the form of delaying interest rate increases, cutting rates and printing money.
Higher interest rates would help the economy
In 2014, I wrote that, in contrast to conventional wisdom, higher interest rates are good for the economy. The conventional wisdom claims that low interest rates increase the size of the “economic pie” by causing people to spend more.
The conventional wisdom misses two crucial aspects. First, the most important impact of low interest rates is not to grow the pie, but rather to take the economic pie away from senior citizens and other savers and give that pie to borrowers. In the U.S., the biggest beneficiary of low interest rates is the biggest debtor — the U.S. government. So low interest rates take money from senior citizen savers and give it to the federal government.
The second underappreciated impact of low interest rates is that it makes people poorer. Thousands of pension plans, college endowments and state retirement plans have been devastated by low interest rates. All savers have suffered because of financial repression. Furthermore, because low interest rates make people poorer, the economy has limped along with anemic growth rates.
Low interest rates have been bad for almost everyone.
As a saver who believes higher interest rates are good for economic growth, I hope that 2017 sees the positive side of the Yellen Collar in action. In particular, it would be great if the federal funds rate could soon exceed 3 percent without crashing the stock market.