Evening Must-Read: Matthew O’Brien: How the Fed Let the World Blow Up in 2008
Matthew O’Brien: How the Fed Let the World Blow Up in 2008: “It was the day after Lehman failed, and the Federal Reserve was trying to decide what to do….
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… and said 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…. The world changed on August 9, 2007. That’s when French bank BNP Paribas announced that it wouldn’t let investors withdraw money…. You can see this credit crunch in the chart… [that] shows the TED spread… during a financial crisis, it blows up: banks charge each other punitively high interest rates, and pile into government bonds they know are safe…. We might [have] muddle[d] through with something like the 1990 recession…. 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….
June 24-25, 2008: 468 mentions of inflation, 44 of unemployment, and 35 of systemic risks/crises…. Eric Rosengren… wasn’t ready to worry about inflation… with the banking system so shaky…. “The recent flurry of articles on Lehman before their announcement of their capital infusion,” he said, “highlights the continued concerns about investment banks.”… 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.”… [He and] Mishkin, Fed Governor Donald Kohn, and then-San Francisco Fed chief Janet Yellen comprised Team: Ignore Inflation…. The rest of the Fed, though, was eager to raise rates soon, if not right away…. Charles Plosser… Kevin Warsh…. 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…. 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 choose to let something disruptive happen.” That is, let a too-big-to-fail bank fail.
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…. 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.”… 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…. 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.”… Warsh… kept insisting that “inflation risks are very real, and I believe that these are higher than growth risks.” And Fisher had more “chilling anecdotes”… Disney World…. Hawks had convinced themselves that the financial crisis had been going on for so long that it wasn’t one anymore…. 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….
September 16, 2008: 129 mentions of inflation, 26 of unemployment, and 4 of systemic risks/crises…. 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…. 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… said, “I remain concerned about the inflation outlook going forward”…. Fisher half-jokingly complained that the bakery he’d been going to for 30 years… had just increased prices…. But it wasn’t just the hawks who wanted to leave rates unchanged. It was everybody at the Fed, except for Rosengren…. 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.
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 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.