The effects of Long-Term Capital Management’s meltdown in 1998 are still being felt today, contends an article in The Wall Street Journal. When the fund, which had borrowed billions, collapsed, the Fed stepped in to rescue it by slashing interest rates to bolster the declining stock market, creating perhaps the first “Fed put.” Once the market was surging again, the Fed didn’t immediately raise rates, and investors took on risks they may have otherwise shied away from. Such rate cuts have been de rigueur during the dot-com bubble burst and the 2008 financial crisis, but the Fed appears to finally be shifting the market away from Fed-put expectations.
Just days after the Federal Reserve Bank of New York orchestrated a $3.5 billion bailout for LTCM, the Fed cut rates in order to prevent a massive selloff in the stock market, which has taken a tumble. Though the rate cuts seemed contradictory to a strong job market and robust income and spending for American households, the Fed reasoned that keeping the stock market strong would bolster annualized consumer spending. Indeed, the stock market boom just prior to the 1998 decline had added over a full percentage-point. But the Fed continued to cut rates well into 1999 even after stocks came roaring back, raising rates by a quarter point at the end of June when the S&P 500 was 13% above its previous record high, the article details.
As tech stocks were soaring in early 2000, Steve Kim, a former strategist at Merrill Lynch, and Paul McCulley, a former manager with Pimco, dubbed the Fed’s actions as “the Greenspan put.” Criticizing the move, they believed it encouraged investors to take on greater risk because of the expectation that the central bank would jump in to save them should another collapse happen. That, in turn, bloated stock valuations. Their fears came to pass when the dot-com bubble burst that year. After Alan Greenspan retired as Fed Chair, the term morphed into the “Fed put” and has stuck around until today, notes The Journal.
In their recent research, economists Anna Cieslak and Annette Vissing-Jorgensen found that while Fed officials don’t look at stocks as a predictor for the economy, they worry that a declining stock market could negatively impact the economy, particularly through wealth effects, prompting to enact the “Fed put.” But stock-market wealth effects don’t seem as pronounced as they may have been 25 years ago; when the S&P 500 fell by 25% last year, no one was really talking about how that would affect household spending, and the Fed still raised rates. Even a new financial conditions index created by the Fed puts less emphasis on stocks than similar models put out by other firms such as Goldman Sachs. So while the Fed is likely to always consider the stock market in their decisions, investors shouldn’t expect an immediate rescue during the next market selloff.