This article argues that many people view the Fed as an insurance policy against financial market risk and believe that the Fed would not allow substantial asset devaluation. My own view is that people ascribe all sorts of motives to the Fed that aren’t there. The Fed is trying to tell us that it’s really simple (as are Kash at Angry Bear and Tim Duy in a Fed Watch). Watch output and inflation relative to target and adjust accordingly. We can argue about how to measure output, the target, and how to parameterize “accordingly” in the Taylor rule, but those are details, the essence is simple. The Fed’s behavior is explained very well with a Taylor rule and reinterpreting it as an insurance program or something else is an entertaining exercise, but we probably shouldn’t take it much beyond there.
However, the broader question of whether the perception that the Fed will protect asset markets is causing overconfidence and excessive risk taking among investors is an interesting issue. For some reason, I’ve been reminded lately of the overconfidence among policymakers in the early 1960s. After the discovery of the Phillip’s curve and the belief that it represented a permanent inflation-unemployment tradeoff, policymakers were very confident in their ability to pick a particular point on the Phillip’s curve and it was widely believed that the stabilization problem was largely solved. History teaches us that such overconfidence in any discipline is generally a bad idea, and the 1970s showed economists that humility is always a valuable trait. Has a run of good luck caused a misperception of the risk of losses so that such overconfidence has emerged again? This article argues there are reasons to believe it has:
Backstopping the Economy Too Well? - Some Experts Worry Greenspan's Success Bequeaths Risky Overconfidence, By Nell Henderson, Washington Post: In financial markets, they call it "the Greenspan put" -- a belief that if stock or bond prices fall too much, the Federal Reserve will help prop them up ... For many home buyers, it's the sense that house prices will keep going higher … thanks in part to Fed policies under Chairman Alan Greenspan. For many lenders, it's the assumption that borrowers … will have no trouble repaying increasingly risky home mortgage and home-equity loans. But according to some Fed observers, this confidence is … worrisome … Greenspan …and other Fed officials have expressed concern about increasingly risky financial behavior … The chairman even felt compelled to state recently that he cannot foresee the future and prevent all bad things from happening. … Investors have come to perceive the Fed's policies of recent years as "free insurance for aggressive risk-taking," said John H. Makin, an economist at the American Enterprise Institute. "Who doubts that a sharp drop in the market for housing or in the stock market would cause Fed [credit] tightening to stop or even to be reversed?" … People may be taking more financial risks because they reasonably expect the economic waters to remain calm, Greenspan suggested in his February report to Congress: "In the United States, only five quarters in the past 20 years exhibited declines in [economic output] and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward." … Greenspan also said recently that the nation's housing boom is an unintended but acceptable side effect of the Fed's efforts to support the economy through difficult times. …
This article essentially asks if recent economic stability is due to good luck or good policy. If you are interested in explanations for the decline in GDP volatility since 1984 such as good luck, good policy, and better technology (inventory management), see Ramey and Vine (2004).