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What Is a Fed Put?
The main goal of the Fed, or the U.S. Federal Reserve, is to maintain a healthy U.S. economy through stable prices and high employment. It does this through measures to stimulate growth, lending, and business expansion, by lowering the Fed Funds Rates, a target rate for banks that drives short- and long-term interest rates throughout financial systems.
From time to time, the Fed also undertakes efforts to add liquidity to the markets by purchasing trillions of dollars of U.S. Treasuries, a practice known as quantitative easing. During bear markets, when prices are rising, unemployment is high, and inflation must be controlled, the Fed tightens the monetary supply through efforts like quantitative tightening, when the Treasuries it bought reach maturity and are erased from its balance sheets.
Much ink has been spilled deciphering the Fed’s actions; nothing they do goes unnoticed. Analysts routinely debate the intrinsic role of the Federal Reserve—specifically what they should and shouldn’t do to regulate financial markets. Those who subscribe to economic theories like the efficient market hypothesis believe that the markets are self-regulating, and that the Fed shouldn’t meddle. Members of the Federal Reserve, on the other hand, believe their role is to make sure the markets don’t tailspin out of control; their careful intervention helps avoid catastrophes like the 1929 stock market crash.
How Is a Fed Put Related to a Put Option?
A Fed put is analogous to put contracts in options investing. A put option is a contract that gives its buyer the right to sell shares of a particular company’s common stock for a set price (the strike price) on or before the date of the contract’s expiration. A put contract can help protect its buyer from declines in the price of the stock they own beyond the strike price of the contract. In a similar way, a Fed put ensures investors that Fed policy will prevent financial markets from crippling declines.
But when investors start to expect that the Fed will come to the stock market’s aid and bail it out in choppy waters, they become prone to taking more risks. As long as the Fed injects liquidity, they reason, there will be a safety net within which to operate. In this type of environment, investors feel more comfortable speculating in riskier assets, like small-cap technology stocks or cryptocurrencies, but a consequence is that asset bubbles, or pockets or sectors of overvaluation, can form.
What Are Some Examples of Fed Puts?
Some believe the Fed steps in with interest rate cuts whenever the stock market enters a bear market, but in a widely circulated 2008 paper called “Market Bailouts and the Fed Put,” President of the Fed Bank of St. Louis, William Poole, dispelled that myth, at least historically speaking. He detailed how, in the period between 1950 and 2006, there were 21 stock declines of 10% or greater, but within three months of each decline, the Fed had either held rates steady or increased them more than half the time (12 instances).
However, what is clear is that in instances of stock market crashes, which are defined as a 10% drop in a stock market index in a matter of days, the Fed does step in with added liquidity.
Here are a few examples:
- After the Black Monday stock market crash of 1987, the Dow fell over 22% in one day. The Federal Reserve, under the helm of newly appointed President Alan Greenspan, issued a one sentence response: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” It then increased loans of Federal Funds by 60% and lowered interest rates, specifically, the Fed Funds rate, by 100 points from 7.5% in October 1987 to 6.5% in February 1988. As a result of Greenspan’s efforts, the term Fed put is also synonymous with the term Greenspan put.
- The 2007–2008 Financial Crisis, which was fueled by the implosion of U.S. mortgage-backed securities, saw the S&P 500 fall 20% in one week in October 2008. In response, the Federal Reserve lowered its target Fed Funds rate from 4.5% at the end of 2007 to between 0% to 0.25% by the end of 2008.
- At the start of the COVID-19 pandemic, the Dow fell over 12% in one day, on March 16, 2020. In response, the Fed again cut the Fed Funds rate to 0% from a previous range of 1% to 1.5% and announced a $700 billion round of quantitative easing measures.
How Does the Fed Increase Liquidity in the Market?
The Fed sets monetary policy by managing interest rates at its FOMC meetings. People view lower interest rates positively because when the Fed cuts rates, it becomes easier for homeowners, for example, to get a mortgage, or a business to buy property to build a new production factory because borrowers will owe their banks less money in interest. The higher the rate of interest, the larger the total sum a borrower will owe their lender and vice versa.
The Fed also increases liquidity through quantitative easing measures. When it purchases trillions of dollars of Treasuries, mortgage-backed securities, or corporate bonds, the Fed drives down long-term interest rates by raising asset prices, or the value of the leftover securities it did not purchase. Doing so also increases its balance sheet, which means it requires banks to keep fewer reserves on hand, which in turn makes it easier for banks to lend to one another, as well as encourages lending among consumers.
In fact, President of the Fed Bank of St. Louis, William Poole, believed that had the Fed stepped in with more expansive monetary policy in the 1930s, it could have prevented many businesses and households from declaring bankruptcy.
How Is a Fed Put Different from a Bailout?
A bailout is an emergency injection of money into a failing company to prevent it from going under. The money could come from a government, another business, or an individual. The term bailout has a pejorative connotation, implying that the company “should have known better” or acted with more caution to avoid such dire straits.
Fed President Poole was quick to point out that the Fed’s assistance should not be considered a bailout. “The Federal Reserve has no funds and no authority to provide capital or guarantees to firms to provide a bailout in the traditional sense,” he wrote. “The Fed cannot even bail out banks. The Fed can make loans to banks, but only loans that are fully secured by good collateral and only to banks that are well capitalized. The Fed can lend to weak banks requiring emergency assistance to prevent immediate collapse, but again only to those with adequate collateral.”
But the Fed needs to be careful its actions don’t inadvertently foster dependency. There is another phenomenon that’s known to happen when the Fed ends its infusion of liquidity—the markets usually experience a temporary downturn, called a taper tantrum. And sometimes, it actually takes another round of quantitative easing to get the markets to settle back down again.
Will There Be a Fed Put in 2022?
TheStreet.com’s Martin Baccardax believes stocks are sinking as investors digest the fact that the Fed’s tightening its focus on fighting inflation—which spells more rate hikes in 2022.
