The Fed Put is Real

The idea that the Federal Reserve is willing to adjust monetary policy in a way that is supportive of the stock market has been debated for decades. A new study by Anna Cieslak and Annette Vissing-Jorgensen puts the argument to rest. They found "compelling evidence of a Fed put going back to the mid-1990s."

The stock market is, of course, not a part of the Fed's dual mandate of stable prices and maximum employment. However, the Fed has often been wary of any negative feedback loop a declining stock market might have on the real economy and pays very close attention to it. But as many people have pointed out, for structural reasons, the stock market does not reflect the economy.

Anyways, back to the study, findings of which is neatly summarized at ZeroHedge:

Analyzing decades of Fed transcripts and minutes, Cieslak and Vissing-Jorgensen found that for every 10% decline in the stock market, a 32 bps rate would result, on average, at the next Fed meeting. The authors tested their model against numerous other macroeconomic variables and found that stock market developments were a better predictor of FOMC than any of them. Their model forecasted a 109 bps cut following the 34% market plunge in Feb-Mar. In response the Fed cut rates by 150 bps.

Not surprisingly, the study also found that an increase in the stock market didn't lead to corresponding increase in interest rates.

This asymmetric response may appear to be decidedly bullish for investors. However, because successive Fed regimes have conditioned traders to expect a dovish Fed response to market volatility, the Fed put could be increasingly less effective in the future (as increasingly bigger responses are needed to get the same effect). As the authors write, for the put to be effective the Fed has to "beat expectations" of how much they will cut. "That's why the Fed's job could get increasing difficult."