The Economics of the Fed Put

We study the impact of the stock market on the Federal Reserve’s monetary policy. We analyze the economics behind the “Fed put,” i.e., the tendency for low stock returns to predict accommodating monetary policy. We show that stock returns are a statistically more powerful predictor of Federal funds target changes than standard macroeconomic news releases. Using textual analysis of FOMC minutes and transcripts, we then argue that stock returns cause Fed policy. FOMC participants are more likely to be concerned about the stock market after market declines and the frequency of negative stock market mentions in FOMC documents predicts target rate cuts. The focus on the stock market reflects Fed’s concern about the consumption-wealth effect and about the impact of the stock market on investment, with less role for the stock market simply predicting (as opposed to driving) the economy. We assess whether the Fed may be reacting too much to the stock market by (a) comparing the sensitivity to the stock market of the Fed’s growth, unemployment and inflation forecasts with the stock-market sensitivity of private sector forecasts, and (b) estimating whether the stock market impacts target changes even after controlling for Fed expectations of economic activity and inflation.