With the Federal Reserve meeting scheduled for Tuesday afternoon, all eyes will likely shift back to Chairman Alan Greenspan and company. The last time the group met, it voted to reduce the federal funds rate by 50 basis points, the 12th cut since January 2001. The series of rate cuts was intended to help jump-start the sputtering U.S. economy, but the Fed is expected to stand pat on interest rates this week. With stock prices now falling and the Dow Jones Industrial Average tumbling 500 points in just five trading sessions, some worried investors are wondering whether the "Greenspan Put" is set to expire. As the nation's central bank, the Fed is in charge of conducting U.S. monetary policy and helps smooth out bumps in the economy through a combination of open-market operations (the buying and selling of Treasury securities) and changes in interest rates. For example, in reaction to an economic recession and the Sept. 11 terrorist attacks, the Fed cut rates 11 times last year. The Fed slashed the fed funds rate from 6.5% to 1.75% in 2001 and lowered it again Nov. 6 to 1.25%. Although the Fed directs its policy at the economy and not at the stock market, investors generally view lower interest rates as a positive for share prices. Lower interest rates add liquidity to the system, so each rate cut is like a liquidity infusion that eventually finds its way into the stock market. Some market watchers believe that the Fed uses interest rates to avert market crashes. Two recent episodes have prompted this notion: the market crash of 1987 and the liquidity crunch of 1998. Both instances caused the Fed to lower interest rates and pump liquidity into the system. Both also resulted in the stock market's rapid recovery.
If investors have put too much faith in the Fed and eventually recognize that reality, it could provide a catalyst for another downturn in the stock market. Investors would be less willing to take on risk, creating a growing sense of risk aversion. In that event, stock prices are likely to fall. Furthermore, given that the Dow Jones Industrial Average has suffered a 500-point decline during the past five trading sessions, Tuesday's (and future) Fed meetings take on even greater importance. Although the Fed is not expected to change interest rates, the wording of its statements as well as hints about future direction of monetary policy can have an important effect on investor confidence.