Fed Put | What Is It? How Does It Work?

What Is The Fed Put?

The so-called Fed Put is the widespread belief among investors that the U.S. Federal Reserve can be relied upon to intervene in the financial markets. Typically, it's believed that the Fed lowers interest rates or uses some other method of easing monetary policy, whenever stock prices fall by a certain amount, thus protecting investors from losses.^[1]

The Fed Put gets its name from a Put option contract, in which the holder agrees to sell a stock or other financial asset at a certain agreed-upon price. In essence, a Put provides the investor with insurance that the price of the stock he owns won't fall further than a specified amount.

"Greenspan Put"

The Fed Put was originally called the Greenspan Put for former Fed Chair Alan Greenspan. He repeatedly lowered interest rates and eased monetary policy following numerous financial and economic crises during his tenure from 1987 to 2006, starting with the one-day stock market crash in 1987.^[2]

After that, market participants began to accept the idea that the stock market would only fall so far before the Fed would intervene, thus boosting prices and rescuing investors from losses. Over the next 15 years or so, under Greenspan's successors Ben Bernanke, Janet Yellen and Jerome Powell, those policies generally continued fairly predictably—although they were never official Fed policy—and the Greenspan Put has come to be called the more generic "Fed Put."

Fed Put Doubts

While the Fed has been largely accommodative to the financial markets since Greenspan's day—from the 2008 global financial crisis all the way through the COVID-19 pandemic—it's possible that the Fed Put may no longer be in effect in the current era of high inflation in 2022. After the Fed started to indicate in late 2021 that fighting inflation was its primary goal and then started raising interest rates and reducing its US$9 trillion balance sheet, stock prices dropped sharply in the bear market, but the Powell-led Fed did not intervene.

Indeed, the episode seemed to show that the Fed Put was only operative in low inflationary environments, when the Fed could feel comfortable easing monetary policy without fear of igniting inflation. However, with inflation in the U.S. running at its highest levels since the early 1980s, the Fed showed no inclination to veer from its newly-hawkish stance of tightening monetary policy.

As Chair Jerome Powell said at a Wall Street Journal-sponsored event in May 2022, "Restoring price stability is an unconditional need. It is something we have to do. There could be some pain involved."^[4]

"We need to see inflation coming down in a convincing way," Powell said. "Until we do, we'll keep going."^[4]

Is The Fed Put Actually Real?

There have been several notable incidents over the past 30 years or so that give credence to economists' idea that the Fed Put is real, or at least fairly reliable, and essentially acts as a third mandate. This would be beyond the actual economic growth mandates of maintaining financial stability and full employment.

Fed Put Examples

As mentioned earlier, following the 1987 stock market crash—when the Dow Jones Industrial Average plunged 22.6%, its largest one-day percentage decline in history—the Greenspan Fed affirmed its readiness to serve as a source of liquidity to support the financial and economic system.^[5] The Fed also intervened in 1998 after the failure of the hedge fund Long-Term Capital Management created a market panic.^[6]

In 2001, the Greenspan Fed also intervened following the bursting of the dotcom stock bubble, when many highly-touted internet stocks fell back to earth.

During the 2008 global financial crisis and after that, the Fed, then led by Ben Bernanke, lowered interest rates to zero and kept them there for years. It also created a new program called quantitative easing in which it bought billions of dollars of U.S. Treasury bonds to drive down long-term interest rates and basically force investors to buy risk assets such as stocks, which eventually helped raise their prices.

In 2020, when much of the global economy largely shut down to try to contain the coronavirus, the Fed, then under Powell, tried two measures to fight the downturn. It returned interest rates back to zero and bought trillions of dollars of both Treasury bonds and government-guaranteed mortgage-backed securities. It also bought corporate bonds for the first time. It also created several new lending programs to help local governments, universities and private companies.

Several other financial crises or events have also been linked to the Fed Put, including the following:^[6]

• The U.S. savings and loan crisis (1990-91)
• The Persian Gulf War (1991)
• Mexican peso crisis (1994)
• Asia financial crisis (1997)
• Russia loan default (1998)
• Y2K (1999)
• 11 September 2001, terrorist attacks

Should The Fed Intervene In Falling Financial Markets?

There is no statutory requirement for the Fed to intervene to try to calm—never mind rescue—volatile financial markets. As mentioned, its only mandates are to maintain price stability and full employment.

It can be argued that keeping financial markets functioning smoothly—as opposed to a bail out for investors and institutions—is a critical and necessary function of any central bank, even if it is not specifically spelled out in their mandate. As a result, since Greenspan's tenure, investors have come to accept—if not expect—the notion of a Fed Put, although there is no formula for predicting at what point the Fed would actually intervene.

In addition to concerns that the Fed or other central bank is overstepping its mandate by intervening in financial markets to help investors stave off losses, there is a related concern that belief in a Fed Put creates a moral hazard issue. That is, it invites excessive speculation by some investors expecting the Fed to come to the rescue if their bets don't turn out as planned.

That creates asset bubbles, such as the dotcom bubble in 2000 and the housing bubble that led to the 2008 global financial crisis. And it can be argued that the stock market rally that started in 2009 and continued into late 2021 was driven to some extent by investor confidence in the Fed Put.^[5]

Is The Fed Put Dead?

This all leads us to 2022, where the Fed has shown no indication of bailing out slumping financial markets as it focuses on bringing down inflation. Does that mean the Fed Put is dead? It may appear so, at least due to today's inflation rate and Powell's aforementioned comments.

Then again, if a major financial institution were to collapse as a result of falling markets, or some other crisis was created, such as if the war in Ukraine spread into the rest of Europe, would the Fed be forced to act? In the meantime, many investors have come to the realisation that the Fed may not be so ready to exercise its Put this time around.

Summary

The "Fed Put" is a belief among investors that the U.S. Federal Reserve will intervene and rescue them from falling stock prices. While doing so is not one of its mandates, the Fed since former Fed Chair Alan Greenspan's term from 1987 to 2006 has regularly lowered interest rates and eased monetary policy in times of market turmoil, to the point where investors have come to expect it.

However, belief in the Fed Put is being sorely tested in 2022, as the Fed battles high inflation by raising interest rates and has shown no indication that it will intervene even as stock markets have fallen sharply in response to the Fed's new hawkish policies.