Is another Black Monday possible?

For all its historical significance, the most notable consequence of the stock market crash 30 years ago last week was not its magnitude or haste — a 23% drop in six hours — but rather a subtle shift in Federal Reserve policy regarding asset values and economic stability.

Over the three decades since Black Monday, increased attention paid by the Fed to financial asset prices played a role in sustaining and backstopping bull and bear cycles in stocks and bonds.

It was not always that way. From its creation in 1913 until the 1987 crash, the economic effects of asset inflation and deflation were not a formal component of Fed policy deliberations.

In November 1977, with the U.S. economy sickened by the toxic mix of slow growth and high inflation, Congress mandated that the Fed achieve the highest possible employment consistent with stable consumer prices and low interest rates. The legislation contained no mention of propping up asset prices or pricking asset bubbles.

Two years later, President Jimmy Carter appointed Paul Volcker to head the central bank, and Volcker soon became legendary for his laser focus on the second of those three mandates — stable inflation — to the apparent exclusion of the others. When Volcker pushed benchmark rates well into double-digits in the early 1980s, unemployment skyrocketed, the economy suffered two recessions and the stock and bond markets cratered.

If Volcker paid attention to the immediate impact that his tight money policies were having on stock and bond prices, it was not evident. Only when inflation abated did Volcker gradually remove his lead foot from the monetary brake, allowing the economy and employment to recover.

To the rescue

By the time Alan Greenspan succeeded Volcker at the Fed in August 1987, the inflationary impact of robust economic growth, a strong labor market and — importantly — a weakening dollar, spurred Greenspan to raise rates. But stocks crashed two months later, setting the stage for what remains an opaque part of Fed policy deliberations and a rationale for why market corrections have become milder and increasingly rare.

“The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system,” Greenspan promised in a statement released the day after the 1987 crash. Contrary to market lore, Greenspan did not cut rates or increase the monetary base. The simple commitment to do whatever it took to rescue the economy was enough to restore confidence.

A decade later, the Fed organized a $3.75 billion bailout of a major U.S. hedge fund whose failure was pressuring stocks and thought to be threatening the financial system.

The use of monetary policy to arrest financial instability or a steep slide in asset prices — a tactic that’s become known as the Greenspan “put” after the option contract that protects against losses — was embraced by Greenspan’s successor, Ben Bernanke.

Different, but the same

Thirty years ago, hedging strategies that used computer-generated sell programs turned a global market correction into a full-blown panic.

Today, risk-reduction tactics employ a more evolved array of vehicles, including so-called volatility control funds that sell stock index futures when volatility spikes. Yet the effect is similar: the more stocks fall, the more stocks are sold.

Combined with decentralized markets, dark money pools and highfrequency trading, a multiday selloff on the scale of Black Monday could be more a matter of when, not if.

But there is reason to think another crash is not on the immediate horizon.

Unlike 1987, investors are more queasy than euphoric. Valuations are stretched only because there are few viable alternatives to equities and because investors think the Fed will come to their rescue if the economic floor gives way.

That decades-old assumption may soon become outdated.

From current levels, there is minimal scope for the Fed to help by cutting rates. Equally important, Fed Chair Janet Yellen’s term expires in February, and if a more hawkish replacement emerges, the Fed could return to the hands-off attitude toward asset prices and financial stability that characterized policy over most of its existence.

The next time things go seriously wrong, you could be on your own.