Market Bailouts and the "Fed Put"
Poole, William, Review - Federal Reserve Bank of St. Louis
This article "was originally presented as a speech at the Cato Institute, Washington, D.C, November 30, 2007.
Federal Reserve Bank of St. Louis Review, March/April 2008, 90(2), pp. 65-73.
Federal Reserve policy actions starting this past August to temper strains in financial markets have generated considerable commentary, some of which reflect concerns that policy action in such circumstances creates moral hazard. The issue is extremely important, and, given that it is so current, this is a good time to reflect in general on the Fed's reactions to financial market developments. The concern over moral hazard is that monetary policy action to alleviate financial distress may complicate policy in the future, by encouraging risky investing in the securities markets. There are so few instances of market turmoil similar to the current situation that I'll broaden the analysis to include significant stock market declines. Doing so gives us a substantial sample to discuss. Thus, my topic is whether Federal Reserve policy responses to financial market developments should be regarded as "bailing out" market participants and creating moral hazard by doing so.
To begin to explore the moral hazard issue, consider an extreme case, which I offer as a provocation to promote careful analysis and not as an example directly relevant to today's circumstances. Fact: The U.S. stock market between its peak in 1929 and its trough in 1932 declined by 85 percent. Question 1: If the Fed had followed a more expansionary policy in 1930-32, sufficient to avoid the Great Depression, would the stock market have declined so much? Question 2: Assuming that a more expansionary monetary policy would have supported the stock market to some degree in 1930-32, would it be accurate to say that the Fed had "bailed out" equity investors and created moral hazard by doing so? I note that a more expansionary monetary policy in 1930-32 would, presumably, have supported not only the stock market but also the bond and mortgage markets and the banking system-by reducing the number of defaults created by business and household bankruptcies in subsequent years.
Now apply these questions to the current situation. Did the Fed "bail out" the markets with its policy adjustments starting in August of this year? Have we observed an example of what some observers have come to call the "Fed put," typically named after the chairman in office, such as the "Greenspan put" or the "Bernanke put"?1 Why has no one, at least not recently to my knowledge, argued that a more expansionary Fed policy in 1930-32 would have "bailed out" the stock market at that time and, by implication, have been unwise?
I can state my conclusion compactly: There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed's dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.
Before proceeding, I want to emphasize that the views I express here are mine and do not necessarily reflect official positions of the Federal Reserve System. I appreciate comments and research assistance provided by my colleagues at the Federal Reserve Bank of St. Louis. However, I retain full responsibility for errors.
My approach will be to start by discussing bailouts and moral hazard in general. I will then examine the record of stock market declines and Fed policy adjustments and analyze how monetary policy changes the nature of risks in financial and goods markets. …