Fed Put

The “Fed Put” is the widespread belief that the US Federal Reserve (commonly referenced as “the Fed”) can always rescue the economy by decreasing interest rates.

The term originates from the analogous comparison of selling a put option on the market. When one sells a put option, that provides the obligation to buy a stock at a predetermined price if the buyer of the put option wants to sell it to you. Similarly, when a central bank is easing monetary policy, it may have an idea of how low it is willing to see the financial markets fall before intervening with liquidity measures to help support their valuations.

The phenomenon was initially termed the “Greenspan put” in reference to then-Fed Chairman Alan Greenspan lowering interest rates in response to the 1998 blow up of hedge fund Long-Term Capital Management (LTCM).

Lower interest rates help stimulate investment by businesses and consumers and enhances the general consumption-wealth effect.

The stock market itself is an important measure for the Fed given its value is well in excess of GDP. The Wilshire 5000 index, which tracks over 3,000 US stocks, currently has a market cap of approximately $30 trillion, putting it about 50% above US GDP, which is just shy of $20 trillion.

Therefore, a drop in the stock market can have a material negative wealth effect that could reverberate throughout the economy. Not only do shareholders lose money, but because business valuations decrease they become less likely to pursue investment opportunities and hire workers. This, in turn, makes consumers less wealthy.

Given the Fed’s statutory dual mandate of maximum employment and price stability, keeping an eye on asset markets and ensuring their stability becomes a type of de facto third mandate. Moreover, given that quantitative easing (QE) runs directly through the financial markets – i.e., the central bank “prints” money and uses it to buy financial assets – the central purpose of this policy is to fundamentally increase the value of asset prices.

When the central bank has put in place accommodative monetary policy in the form of low or zero interest rates and quantitative easing, the expectation is that the “Fed put” will hold either by making policy even more accommodative or through temporary liquidity injections to help prop up the market.