The Economics of the Fed Put
65 Pages Posted: 14 Apr 2017 Last revised: 25 Oct 2018
Date Written: September 1, 2018
We document that low stock market returns predict accommodating monetary policy by the Federal Reserve. Negative stock returns realized between FOMC meetings are a more powerful predictor of subsequent federal funds target rate changes than almost all macroeconomic news releases. Using textual analysis of FOMC minutes and transcripts, we argue that stock returns cause Fed policy and document the mechanism underlying the relation. Consistent with a causal effect of stock returns on policy, FOMC participants are more likely to mention the stock market after market declines - a pattern that arises from the mid-1990s - and the frequency of negative stock market mentions in FOMC documents predicts target rate cuts. The FOMC discusses the stock market mostly as a driver of consumption and, to a lesser extent, investment and broader financial conditions. Less attention is focused on the stock market simply predicting (as opposed to driving) the economy. In a Taylor rule framework, about 80% of the Fed's reaction to the stock market can be explained by the Fed revising its expectations of economic activity down following stock market declines. The Fed's expectations updating is roughly in line with that of private sector forecasters and with the stock market's predictive power for growth and unemployment.
Keywords: Fed Put, Monetary Policy, Stock Market, Textual Analysis, Taylor Rules
JEL Classification: E52, G12
Suggested Citation: Suggested Citation