Black Monday and the Federal Reserve: A Tale of Financial Crisis

On a gloomy Monday morning, October 19, 1987, the world woke up to a financial nightmare.

The stock market tumbled, making a grand entrance into the history books as "Black Monday". The Dow Jones Industrial Average (DJIA) fell a staggering 22.6% in a single trading session, an infamous record that still holds today​1​.

It was a day that had investors clutching their chests, traders reaching for their phones, and the Federal Reserve, America's central bank, springing into action.

In the days leading up to the crash, the markets were not exactly full of sunshine and rainbows.

The preceding week had been bearish, with the headline indexes dropping around 10%​​.

There were warning signs. Economic growth had slowed, inflation was on the rise, and the strong dollar was putting pressure on U.S. exports.

The stock market and economy were diverging for the first time in the bull market, with valuations soaring to excessive levels​2​.

During this period, the financial world was also getting its first taste of automation.

Program-driven trading models following a portfolio insurance strategy were becoming popular.

Initially intended to limit portfolio losses, this strategy used computer programs that would automatically liquidate stocks as certain loss targets were hit.

However, as the markets began to fall, these programs triggered a domino effect. The frantic selling activated further rounds of stop-loss orders, plunging markets into a downward spiral and exacerbating the decline​2​.

Now, picture the Federal Reserve, freshly helmed by Chairman Alan Greenspan. Greenspan, expecting a drop in the value of the dollar due to an international tiff with the other G-7 nations over the dollar's value, was instead greeted with a worldwide financial meltdown​2​.

It was like expecting a light drizzle but being hit by a hurricane!

The Fed's Response

So, how did the Fed respond? As the world looked on anxiously, the central bank sprang into action.

Chairman Greenspan affirmed the Federal Reserve's readiness to serve as a source of liquidity to support the economic and financial system.

Behind the scenes, the Fed encouraged banks to continue lending on their usual terms.

This move was seen as a money-losing strategy from the point of view of the banks (and the Fed), but it was a good strategy for the preservation of the system as a whole. In fact, during that week, the 10 largest New York banks nearly doubled their lending to securities firms​1​.

The Fed's response was a pivotal moment in financial history.

For the first time, the sharp losses from a major financial crisis were not followed by an economic recession or a banking crisis.

It was a bold testament to the power of the Federal Reserve to calm severe market downturns and boost investor confidence​1​.

The Impact of Black Monday and the Fed

However, the story doesn't end there. Black Monday led to a series of reforms. Exchanges developed provisions to pause trading temporarily in the event of rapid market sell-offs.

In response to the breakdown of market balances between buy and sell orders, major exchanges instituted various types of trading curbs, often called circuit breakers.

These circuit breakers were designed to halt market trading and allow investors time to gather their thoughts, in hopes that markets will stabilize once the trading curb is lifted​2​.

The aftermath of Black Monday served as a lesson for future financial crises. Despite the chaos, the Federal Reserve's response during Black Monday set a precedent for the central bank's use of "liquidity" to stem financial crises, ushering in a new era of investor confidence.