Is the Fed Put Kaput?

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Given the stock market turmoil, a timely question is whether the U.S. Federal Reserve (the “Fed”) will act to stem the tide of losses as it has done during prior stock market declines. A bloated Fed balance sheet and historically high inflation suggest that this time the Fed will be unable to act to save the market.

Fed to the rescue – The Fed put

The Fed put, or the belief on the part of financial market participants that the Fed will take aggressive action to prevent major stock market declines, arose during Alan Greenspan’s tenure as chairman. During this period, which ran from 1987 to 2006, the Fed embraced a policy of supporting the economy and the stock market during times of stress by lowering interest rates and adopting other accommodative measures. As a result, the term “Fed put” came about as a play on the term “put option,” which is a type of option designed to limit losses.

The concept of the Fed put rose in popularity during the 1987 stock market crash when the Fed quickly acted to lower interest rates and preserve liquidity within the financial system to prevent a protracted decline in stock prices caused by the widespread, and imprudent, use of option and derivative strategies known as portfolio insurance. As a result of the Fed’s aggressive actions, the stock market quickly recovered. However, in so acting, the Fed also established the precedent that it would intervene to backstop the economy and the stock market during times of crisis.

This precedent was reinforced by subsequent Fed actions to support the stock market during the savings and loan crisis, the Gulf War, the Asian financial crisis and the collapse of Long-Term Capital Management. However, it was the Fed’s actions during the bursting of the dotcom bubble that solidified the existence of the Fed put in the minds of investors. During this period, which ran from March 2000 to October 2002, the stock market suffered a severe downturn caused by a collapse in telecommunications and internet-related stocks. To address this decline, in 2001, the Fed adopted a sustained program of reducing interest rates as a means of supporting the stock market and the economy. This accommodative policy worked so well that the Fed continued it through the end of Greenspan’s tenure as Fed chairman.