It was the day after Lehman failed, and the Federal Reserve was trying to decide what to do.
It had been fighting a credit crunch for over a year, and now the worst-case scenario was playing out. A too-big-to-fail bank had just failed, and the rest of the financial system was ready to get knocked over like dominos. The Fed didn't have much room left to cut interest rates, but it still should have. The risk was just too great. That risk was what Fed Chair Ben Bernanke calls the "financial accelerator," and what everyone else calls a depression: a weak economy and weak financial system making each other weaker in a never-ending doom loop.
But the Fed was blinded. It had been all summer. That's when high oil prices started distracting it from the slow-burning financial crisis. They kept distracting it in September, even though oil had fallen far below its July highs. And they're the reason that the Fed decided to do nothing on September 16th. It kept interest rates at 2 percent, and intoned that "the downside risks to growth and the upside risks to inflation are both significant concerns."
In other words, the Fed was just as worried about an inflation scare that was already passing as it was about a once-in-three-generations crisis.
It brought to mind what economist R. G. Hawtrey had said about the Great Depression. Back then, central bankers had worried more about the possibility of inflation than the grim reality of deflation. It was, Hawtrey said, like "crying Fire! Fire! in Noah's flood."
The world changed on August 9, 2007. That's when French bank BNP Paribas announced that it wouldn't let investors withdraw money from its subprime funds anymore. It couldn't value them, because nobody wanted to buy them. The effect was immediate. Banks stopped trusting, and lending to, each other. They all had their own subprime problems, but none of them knew whose was the worst—or who had insured whom.
You can see this credit crunch in the chart below. It shows the TED spread, the difference between short-term rates on government debt and interbank loans, for 2007 and 2008. Normally, there isn't much of a difference between the two. But during a financial crisis, its blows up: banks charge each other punitively high interest rates, and pile into government bonds they know are safe.
Now, the Fed actually did a good job in this first part of the crisis. It aggressively cut interest rates from 5.25 percent in September 2007 to 2 percent in April 2008. And it midwifed a deal for Bear Stearns—taking on $30 billion of its crappiest assets—to prevent an all-out panic. By April, Bernanke was justified in saying that "we ought to at least modestly congratulate ourselves." The TED spread had come down from end-of-the-world-terrible to merely terrible levels. And though unemployment had risen to 5.4 percent, that wasn't too bad when you considered that housing had already fallen 20 percent from its 2006 peak.
It looked like we might muddle through with something like the 1990 recession: a shallow, but long, slump, with a weak financial system, but no panic. This is the three-chapter story of why that didn't happen, the story of the three Fed meetings that took place during the summer of 2008, whose much-anticipated transcripts were finally released last week.
1. June 24-25, 2008: 468 mentions of inflation, 44 of unemployment, and 35 of systemic risks/crises
It was, Fed governor Frederic Mishkin said, "a perfect storm of shocks."
The economy was still teetering, the financial system was still paralyzed, and oil prices were still skyrocketing. The question was whether the Fed should be more concerned about markets melting down or prices melting up.
Boston Fed president Eric Rosengren, for one, wasn't ready to worry about inflation—not with the banking system so shaky. He'd done research that showed that Japan's credit crunch in the 1990s had even hurt U.S. businesses, so he wasn't going to underestimate our own. "The recent flurry of articles on Lehman before their announcement of their capital infusion," he said, "highlights the continued concerns about investment banks." His concerns extended to their counterparties—money market funds—which he pointed out would have broken the buck if Bear Stearns had gone into bankruptcy.
Rosengren wasn't nearly as concerned with 5 percent headline inflation—and with good reason. He reminded his colleagues that "monetary policy is unlikely to have much effect on food and energy prices," that "total [inflation] has tended to converge to core, and not the opposite," and that there was a "lack of an upward trend of wages and salaries."
In short, inflation was high today, but it wouldn't be tomorrow. They should ignore it. A few agreed. Most didn't.
Mishkin, Fed Governor Donald Kohn, and then-San Francisco Fed chief Janet Yellen comprised Team: Ignore Inflation. They pointed out that core inflation hadn't actually risen, and that "inflation expectations remain reasonably well-anchored." The rest of the Fed, though, was eager to raise rates soon, if not right away. Philadelphia Fed president Charles Plosser recognized that core inflation was flat, but still thought they needed to get ready to tighten "or our credibility could soon vanish." Fed Governor Kevin Warsh said that "inflation risks, in my view, continue to predominate as the greater risk to the economy," because he thought headline would get passed into core inflation.
And then there was Dallas Fed chief Richard Fisher, who had a singular talent for seeing inflation that nobody else could—a sixth sense, if you will. He was allergic to data. He preferred talking to CEOs instead. But, in Fisher's case, the plural of anecdote wasn't data. It was nonsense. He was worried about Frito-Lays increasing prices 9 percent, Budweiser increasing them 3.5 percent, and a small dry-cleaning chain in Dallas increasing them, well, an undisclosed amount. He even half-joked that the Fed was giving out smaller bottles of water, presumably to hide creeping inflation?
By the way, I notice that these little bottles of water have gotten smaller—this will be a Visine bottle at the next meeting. [Laughter]
In the end, the Fed left rates unchanged at 2 percent, but did change its policy statement to say more about inflation. Bernanke thought that the new "inflation paragraph is a little more hawkish"—and markets agreed. You can see that in the chart below, which looks at how rate expectations changed from May to June to July 2008.
Higher oil prices, and the Fed's hawkish words about them, convinced markets that rates would rise further and faster than they had thought before. It was effectively a 30 basis point tightening, just when the economy could least afford it.
And the economy really couldn't afford it if they decided, like Richmond Fed president Jeffrey Lacker suggested, that "at some point we're going to have to choose to let something disruptive happen." That is, let a too-big-to-fail bank fail.
2. August 5, 2008: 322 mentions of inflation, 28 of unemployment, and 19 of systemic risks/crises
The economy was getting weaker, and the hawks were getting bolder.
Losses were piling up at the investment banks and Fannie and Freddie. Consumers were cutting back, especially on big-ticket items like cars, because they couldn't get credit. And oil prices were falling fast from their July highs. Now, headline inflation was still around 5 percent, but it was drifting down, and the Fed's economists expected it to keep doing so: they cut their second-half forecast for it by almost a full percentage point in August.
But even though inflation was falling, it was a lonesome time to be a dove. As the Fed's resident Cassandra, Rosengren tried to convince his colleagues that high headline inflation numbers "appear to be transitory responses to supply shocks that are not flowing through to labor markets." In other words, inflation would come down on its own, and the Fed should focus on the credit crunch instead. Mishkin worried that"really bad things could happen" if "a shoe drops" and there was a "nasty, vicious spiral" between weak banks and a weak economy. Given this, he wanted to wait to tighten until inflation expectations "actually indicate there is a problem," and not before.