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All you wanted to know about Yellen Put

LOKESHWARRI S K | Updated on January 22, 2018

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The Federal Reserve’s decision not to hike its benchmark rate last week has revived the debate around the existence of a Fed Chairperson put; or Yellen Put.

What is it?

A put is a derivative contract that gives investors protection from losses on their investments. If an asset’s price declines, a put starts making money, thus shielding the investor from the prospect of losses. The references to puts associated with the US Fed chairperson have come about because of the US central bank’s tendency to step in with monetary easing, either through an interest rate cut or with liquidity infusion , whenever financial markets plunge.

The term was first coined in 1987 when Alan Greenspan threw the might of the Fed behind a flailing stock market. It was then called ‘Greenspan put’. The Federal Reserve then initiated a series of actions to provide support to financial market participants including massive open market operations, issuing public statements saying that the Fed is committed to providing liquidity and asking commercial banks to lend to the intermediaries.

Then came the ‘Bernanke put’, as Ben Bernanke came to the rescue of investors after the 2008-crash. Measures initiated by him such as slashing the Federal Funds rate to close to zero and the launch of bond re-purchase programme helped put a floor to financial markets.

Now, Yellen appears to be following the footsteps of her predecessors. She has said that she will consider ‘readings on financial and international developments’ to decide on the future rate hikes. This reinforces the view that the Federal Reserve is watching financial markets closely and will not hike rates, if the markets appear weak or unprepared for the event.

Why is it important?

There’s a debate raging on, on the extent of influence that the financial sector should have on central bank policies. There are some that say the real economy that deals with the actual production of goods and services is more important than the financial economy that deals with buying and selling of assets.

But research shows the two arelinked. In a paper published by the Bank for International Settlements, Konstantinos Tsatsaronis says asset prices do impact both demand and supply, as expectations of the private sector are embedded in the prices of financial and real assets. Asset prices impact the ability of companies to borrow, as the borrower’s assets are used as collateral for the loan.

So, it is not surprising that central bankers are tuned in to the signals emanating from financial markets, while considering any significant action.

Why should I care?

We have not heard of a ‘Reddy put’ or a ‘Rajan put’ but Indian central bankers have also been quite sensitive to the actions of financial markets. For instance in the dotcom crash of 2001, as stock markets plunged, Bimal Jalan slashed the benchmark rates from 8.5 to 4.5 per cent. Similarly, between July 2008 and April 2009, D Subbarao brought down the rates from 9 to 4.75 per cent even as markets crashed here. It is therefore apparent that central bankers are watching financial markets closely, even though they keep brushing aside any suggestion that they are doing so.

Central banker ‘puts’ enhance the case for holding equity assets. It is unlikely central banks will allow prices to fall to unreasonable depths and are quite likely to pump in liquidity to take prices higher; should the need arise.

The bottomline

Rest easy and keep faith in the central bank put.

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