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.
The hawks didn't want to wait. Lacker admitted that wages hadn't gone up, but thought that "if we wait until wage rates accelerate or TIPS measures spike, we will have waited too long." He wanted the Fed to "be prepared to raise rates even if growth is not back to potential, and even if financial markets are not yet tranquil." In other words, to fight nonexistent wage inflation today to prevent possible wage inflation tomorrow, never mind the crumbling economy. Warsh, for his part, kept insisting that "inflation risks are very real, and I believe that these are higher than growth risks." And Fisher had more "chilling anecdotes"—as Bernanke jokingly called them—about inflation. This time, the culprit was Disney World and its 5 percent price increase for single-day tickets. (What were they doing, opening a park in Zimbabwe?).
The Fed was stuck in the same place in August that it'd been in June, even though the commodity spike was already fading. Hawks were scared of inflation, doves were scared of a depression, and everyone else wasn't sure which to be more scared of. So, once again, the Fed left rates unchanged at 2 percent, but did change its policy statement to say even more about inflation than the last time. Bernanke said that it was his "intention for [the statement] to be slightly hawkish—to indicate a slight uplift in policy."
It was a mistake, but it was nothing like the one that was to come. Hawks had convinced themselves that the financial crisis had been going on for so long that it wasn't one anymore. That banks had had more than enough time to cut their exposure to troubled firms. That one bankruptcy, say Lehman's, wouldn't cause a cascade of others. Or, as St. Louis Fed president James Bullard put it, that "the level of systemic risk has dropped dramatically, and possibly to zero."
This was Mishkin's last Fed meeting before he returned to Columbia, and what he was hearing scared the bejeezus out of him. He made sure his soon-to-be-ex-colleagues remembered that a crash could, in fact, come long after a crisis started—with a historical comparison to make a central banker blanche.
Remember that in the Great Depression, when—I can’t use the expression because it would be in the transcripts, but you know what I’m thinking—something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock.
Then he left the Fed with one last lesson, what he drolly called his "valedictory remarks." Actually, it was Milton Friedman's lesson, but Mishkin wanted to make sure they didn't forget it. That was "the danger of focusing too much on the federal funds rate as reflecting the stance of monetary policy." In other words, just because interest rates were low didn't necessarily mean that policy was easy—and vice versa. You could only tell by either looking at other interest rates, or inflation, or nominal GDP.
This was textbook economics—in fact, Mishkin had a whole chapter on it in his textbook—but the hawks kept getting it wrong. Lacker and Kansas City Fed chief Thomas Hoenig insisted that the Fed's 2 percent rates meant money was easy. But, as Bernanke explained, the facts disagreed. Mortgage rates had gone up even as the Fed had cut, so that the gap between the them had increased from 120 basis points in 2007 to 260 basis points in 2008. Money was getting tighter, not easier, for households.
This had enormous implications for policy. If the Fed realized that money was tight despite low rates, then it would try to do more. But if the Fed assumed that money was loose, because rates were low, then it'd say there wasn't any reason to try to do more, it was already doing a lot! It'd sit by and watch a slump go on, and on, and on, like the Fed in the 1930s or the Bank of Japan in the 1990s. This was the history that Mishkin hoped the Fed wouldn't, but feared would, repeat—and not only because he'd recently bought a second house.
I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. I’m holding two houses right now. I’m very nervous.
3. September 16, 2008: 129 mentions of inflation, 26 of unemployment, and 4 of systemic risks/crises
"We have a lot to talk about," Bernanke said. That they did. Lehman had failed the day before, and markets were trying to figure out what it meant. After some consideration, they decided it was the end of the world.
It was easy to see why. Markets had expected Lehman to be bailed out. Lehman had expected Lehman to be bailed out. So when it wasn't, nobody was prepared. It wasn't clear who had lost what, and who had claims on what. But what was clear was that the insurance giant A.I.G. was going to need a bailout. That money market funds were, as Rosengren had warned, about to break the buck. And that there was a run on every financial asset that wasn't guaranteed by the government.
The Fed, though, was surprisingly upbeat. Lacker had gotten the "disruptive" event he had wanted, and he was pretty pleased about it. "What we did with Lehman I obviously think was good," he said, because it would "enhance the credibility of any commitment that we make in the future to be willing to let an institution fail." Hoenig concurred that it was the "right thing," because it would suck moral hazard out of the market.
That doesn't mean the Fed wasn't worried. It was worried. About inflation.
The hawks were monomaniacally focused on headline inflation that hadn't yet fallen all the way from its summer peak. Even though commodity prices and inflation expectations were both falling fast, Hoenig wanted the Fed to "look beyond the immediate crisis," and recognize that "we also have an inflation issue." Bullard thought that "an inflation problem is brewing." Plosser was heartened by falling commodity prices, but said, "I remain concerned about the inflation outlook going forward," because "I do not see the ongoing slowdown in economic activity is entirely demand driven." And Fisher half-jokingly complained that the bakery he'd been going to for 30 years—"the best maker of not only bagels, but anything with Crisco in it"—had just increased prices. All of them wanted to leave rates unchanged at 2 percent.
But it wasn't just the hawks who wanted to leave rates unchanged. It was everybody at the Fed, except for Rosengren. He was afraid that exactly what did end up happening would happen. That all the financial chaos "would have a significant impact on the real economy," that "individuals and firms will be become risk averse, with reluctance to consume or invest," that "credit spreads are rising, and the cost and availability of financing is becoming more difficult," and that "deleveraging is likely to occur with a vengeance." More than that, he thought that the "calculated bet" they took in letting Lehman fail would look particularly bad "if we have a run on the money market funds or if the nongovernment tri-party repo market shuts down." He wanted to cut rates immediately to do what they could to offset the worsening credit crunch. Nobody else did.
Even the day after Lehman, the Fed wasn't sure whether inflation or the financial crisis was the bigger risk to the economy. They wanted to wait and see what the data said. But if they had looked at what the markets were telling them, they wouldn't have had to. 5-year TIPS spreads had been falling fast, and, by September 16th, showed that markets only expected 1.23 percent inflation. Some of that was because TIPS are illiquid, but not all of it. The fall in commodities and the rise in unemployment—which Fed economists saw "no reason to discount"—also said that demand was disappearing slowly, then all at once.
But the Fed didn't see it that way. It thought housing was going to stabilize, the financial crisis was going to abate, and oil prices were going to keep coming down, so that GDP growth would pick up in 2009. Bernanke thought that the Fed's 2 percent interest rate was "the policy path consistent with achieving our objectives" and that a rate cut was premature:
Overall I believe that our current funds rate setting is appropriate, and I don’t really see any reason to change.... Cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward, and I think we should view that step as a very discrete thing rather than as a 25 basis point kind of thing. We should be very certain about that change before we undertake it because I would be concerned, for example, about the implications for the dollar, commodity prices, and the like.
And so the Fed kept the firehoses ready while the economy drowned.
What was to be done?
None of this was inevitable. The Fed could have ignored oil prices that summer, and told us it was ignoring them. And it could have saved Lehman that fall. It wouldn't have been easy—or popular—but it wouldn't have been impossible, either. That's clear if you look at what Rosengren was saying in real-time. With that in mind, here's a look at what the Fed could have, and didn't do, to make the Great Recession a little less so.
1. Oil shock. Graded on a curve, the Fed did okay. At least it didn't raise rates that summer like the ECB did. But on an absolute scale, the Fed could have done better. It could have done in 2008 what it did in 2011, when another oil spike came along: say that the increase in inflation was transitory, and they were focused on long-term inflation expectations instead.
Now, more dovish language that summer wouldn't have saved the world. But it would've kept money a little looser. And that could've given the financial system a little more breathing room to keep raising capital, like the Fed had been doing before.
2. Lehman. There are three magic words in central banking: whatever it takes. The Fed did that with Bear. It didn't do that with Lehman. It could have let Lehman become a bank holding company, which is what Lehman wanted, and what the Fed ended up doing for Goldman Sachs and Morgan Stanley a few weeks later. Or it could have given Lehman bridge financing to try to finish a deal after everything fell through on September 14th. None of these would have been popular decisions, but what's the point of an independent central bank if it won't do unpopular things to save the economy?
After the fact, the Fed has said that it couldn't do these things, that it had no choice. But the transcripts show that it was a choice, and they knew it. Some of them thought nothing bad would happen. And they were happy about it in September—well, all but Rosengren—until they realized what a world-historical error it was.
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