The Fed's unexpected 5obp cut ini the primary credit discount rate on 17 August 2007 helped a 2.5% daily rally in the S&P 500. It could be argued that the cut was an attempt to stabilise the market and that in this case the Fed acted to deal with (or to attempt to head off) a systemic crisis linked to a (now) well-publicised credit crisis. However, commentators have raised the notaion of a "Fed Put" (previously known as the Greenspan Put in reference to the former Fed chairman).

A put is an option contract (e.g. on the S&P 500) that enables the buyer of the contract to sell an item (e.g. a stock or stock index) for a certain price at a specific date. The contract therefore protects buyers from declines in price beyond a certain (strike or exercise) price.

The Fed Put alludes to a Fed policy that protects, for example, stock market investors or other risk takers from declines beyond a certain price point. Shortterm rallies in stock markets have been synonymous with Fed rate cuts. Such a move is interesting, as neither the Fed nor interest rate policy have the power to keep the stock market at a defined level because there is inherently no definition of what this level should be. There is also a potential moral hazard (encouraging speculation by providing a safety net) by the Fed bailing out risk takers in the market. This behaviour could be at the expense of the US dollar and without due regard to present and future inflation implications.

Similarly, the Fed guaranteed bailout/JPMorgan buyout of Bear Stearns crystallised the view that some institutions are too important, at least to the market, to be allowed to fail. The question of whether the sum of these actions encourages risktaking by providing a government safety net may be abstract to Bear Stearns’ shareholders (and employees) nursing eavy losses but it does raise the moral hazard issue from a wider perspective.

Spot the trend?
Figure 1 shows the S&P 500 against the Fed policy rate from January 1950 to January 2008. The triangles (p) show points in the S&P 500 (a total of 21) followed by a 10% decline.

The analysis indicates that within three months of such stock market declines the Fed held the rate constant or increased it on 12 occasions and cut it nine times. However, the Fed acted before the stock market peak on five of the nine cuts so the direct link is weak. The two main examples of the Fed cutting rates following peaks were in September 1976 and July 1998 (a response to Long Term Capital Management rather than the stock market). Additionally, the bursting of the technology equity bubble in March 2000 also triggered a number of cuts as the Fed tried to stimulate the US economy.

A range of factors determines interest rate policy for a country or economic block. However, within the context of the Fed, it is clear that policy is determined on a wider macroeconomic level rather than on equity levels. In 2008, we have seen aggressive Fed cuts from 4% to 2%.

The same period has been marked by an approximate 10% decline in the S&P 500 (to 30 June 2008) and more importantly an ongoing credit and liquidity crisis.

Balancing act
A key role of the Fed is to help “markets reassess and price risk that will ultimately lead to the establishment of new levels of prices… During this adjustment process, the central bank must also ensure the orderly functioning of financial markets”, said Philadelphia Fed President Charles Plosser in 2008.

Overall, there is certainly a hint of a Fed Put but the moral hazard inferred within this is weak – in terms of risk takers’ behaviour being reliant on Fed actions. Monetary policy (in collaboration with fiscal policy) is designed to stabilise price levels over time and, in the words of the Employment Act 1946, the US congress wanted the Fed to “promote maximum employment, production and purchasing power”.

It is apparent that the Fed has a very close eye on a possible US recession and, in fact, wants to do everything possible to avoid the dreaded R-word. However, monetary policy has always been a battle between short and long term implications – the analogy is that interest rate cuts are like a “gas pedal” to accelerate economic growth and avoid recession, while raising rates is like applying the “brakes” to slow an economy and moderate price inflation. The Fed, faced with the twin perils of a slowing economy and inflation has chosen, thus far, to focus on the former (at the expense of the “purchasing power” part of the Employment Act).

The difficult balancing act of Fed monetary policy can perhaps be summed up by the role of a forecaster – “perhaps more akin to a cross-eyed javelin thrower: they don’t win many accuracy contests, but they keep the crowd’s attention,” (anonymous). With US interest rates arguably close to the bottom of the cycle and a weak US dollar, the Fed (and other central banks) are caught battling inflation i nto the headwind of a slowing global economy. As such, given inflationary concerns, there seems little hope that the Fed will be casting the market any further short-term lifelines in the foreseeable future. The question of a Fed moral hazard seems to be limited – the bottom line being that the sheer weight of assets and interflow of worldwide capital is too great for an institution, even one as powerful as the Fed, to steer over the longer term.

 

Source: “Market Bailouts and the Fed Put” by William Poole; “The Economic Outlook and the Fed’s Roles in Monetary Policy and Financial Stability” by Charles Plosser; and “The Federal Reserve System Purposes and Functions”, United States Federal eserve System Publication 2005.