May 2024

The Fed Put

“The U.S. government can’t go bankrupt because we can print our own money.” Jared Bernstein

In the 1970s, Federal Reserve chairman, Arthur Burns, a Keynesian economist, attempted to rescue an economy hobbled by price controls, protectionist trade policies, and misguided fiscal policies, with monetary stimulus. Burns’ loose money scheme not only failed to achieve the desired result, but instead created an economic environment later coined stagflation; low growth accompanied by high inflation.

Surprising no one, President Carter replaced Burns with Bill Miller. Mr. Miller’s term lasted a scant two years. He was succeeded by Paul Volker, a monetarist, who was tasked by President Reagan with snuffing out inflation once and for all. Volker took his job seriously; his monetary chemotherapy resulted in an unprecedented 22% federal funds rate which, not surprisingly, collapsed aggregate demand—in other words, produced a severe recession. But Volker accomplished what he set out to do, and the CPI dropped from a high of 13.5% in 1980 to just 1.1% by 1986.

Volker’s term ended in 1987, and he was replaced by Alan Greenspan. Greenspan took his place in the big chair at a time when the economy had expanded by an average annual rate of 4.57% over the prior five years, and inflation had averaged just 3.32% during the same period. With price levels under control, Greenspan really had one goal; don’t screw it up.

Mr. Greenspan’s term lasted nearly 19-years; the second longest in Federal Reserve history. Under his watch, the economy and wages grew significantly, inflation was subdued, and the stock market averaged 10% annual returns. Rising stock and real estate prices amplified the wealth effect, and both household wealth and wages grew at an unprecedented rate.

This uniquely prosperous period led many to perceive Mr. Greenspan as a genius. A magic man with the Midas touch. Central bankers were supposed to be introverted, stuffy, academics, sporting drab Brooks Brothers suits. Yet, within a handful of years Greenspan achieved near celebrity status, and his iconic visage was equally likely to be found in pop and culture publications as economic journals. Sebastian Mallaby even penned a book about him entitled, “The Man Who Knew.” Mr. Greenspan enjoyed near cult-like status during his reign at the largest, most powerful financial institution in the world. When his term ended in 2006, he went out on top, as they say.

Greenspan is remembered for two things in particular. The first being Fed speak, or his remarkable ability to talk for hours on end in vague, cryptic, nuanced language, which typically left market pundits scratching their heads as to what he actually said, and the direction of monetary policy.

The second thing being the “Greenspan (Fed) put.” In a nutshell, the Fed put refers to the point at which the central bank will take action to support asset prices (the stock market) by shifting to easy money policies. The notion of a Fed put is generally attributed to the bank’s reaction to Black Monday, when the stock market dropped an unprecedented 22.6% percent in a single day. Greenspan’s dovish response set a dangerous precedent for central bank intervention to calm financial markets.

Subsequent events, such as the S&L meltdown, Gulf War, Asian currency crisis, Long-Term Capital Management collapse, and dot-com bubble implosion, resulted in a similar Fed response. The most notable being the tech bubble, which burst in 2000, after which Greenspan applied a heavy dose of monetary salve to stabilize the stock market.

While investors cheered, objective pundits understood this was a perilous, if not reckless path. Applying monetary morphine every time stock prices dropped would both reward and increase risk-taking; a phenomenon known as morale hazard. And why shouldn’t investors do so? If the Fed was committed to indirectly insuring investors against significant loss, then one should go all-in and enjoy the upside, knowing the Fed will support the markets when the poop hits the fan.

Less than two years after Greenspan handed the reigns to Ben Bernanke in 2006, the US, along with most of the western world, was in the middle of the Great Financial Crisis. While there were a number of culprits who contributed to the meltdown, the Fed was certainly among them, and likely in the top three. Excessively loose monetary policy always and everywhere creates distortions, inflating risk asset prices, incentivizing leverage and therefore risk, and punishing savers with artificially low returns on traditional bank products.

While the economy has thus far avoided a widely expected recession, unprecedented monetary and fiscal stimulus both during and after the pandemic have muted or distorted traditional economic indicators, leading to significant uncertainty regarding economic outlook. As the Fed navigates the challenges of maintaining stability and supporting growth, investors face a period of heightened volatility and uncertainty. With election years historically favoring investors, the question arises: if stock prices retreat between now and November, will the Fed maintain its independence and resist the temptation to deliver a Powell put? Only time will tell.

Mark Lazar, MBA
CERTIFIED FINANCIAL PLANNER™