In Their Own Words: The Fed Heads Were Dead Wrong In 2008. Deja Vu Anyone?

by Jeffrey P. Snider

I suppose when your entire task derives from regression-based statistics, there is the tendency to incorporate straight lines into even your own thought patterns. Of course, that leads to self-reinforcing bias and should be canceled by some governing process. Usually that governing process takes the form of applied knowledge (as opposed to math-based knowledge) and plain common sense. In a large organization, such as the Federal Reserve, the barriers to even common sense are myriad and end up as inertia. Any human endeavor or system, or even any natural system, takes cyclical form. In the case of economics and particularly financial function, there are evident ebbs and flows in the progression to either end. Yet, captured in linearity, these ebbs and flows look something far different separated from a grounded basis in humanity. When the Fed arrived at the precipice of panic in September 2008, there was more than a fair bit of shock at what was unfolding. As I have noted before, the FOMC was far, far more concerned with inflation than anything else, including the potential for severe panic and related economic catastrophe. The reason for that, as I will show here, was this inability to see beyond linear extrapolation – the economists believed they had solved all problems with their actions earlier that year. It is more than fair to conclude that all of the FOMC members saw the failure of Bear Stearns as the nadir, the conclusion that ended the entire episode. Thus, the ebb in crisis between March 2008 and August 2008 was seen as the final expression of a worst case. That view was more than shared by Janet Yellen, the current incarnation of monetary genius and savior. All of the following are taken from the June 24, 2008, FOMC transcripts: YELLEN. The strong incoming data on spending eased my fears that we are in or are approaching a recession regime of the sort embedded in the last two Greenbooks. However, given the numerous large and worsening drags on spending, a couple of months of data aren’t enough to convince me that we are on a solid trajectory… Higher oil prices and interest rates and lower housing prices have led me to modestly reduce my forecast of growth in the second half of this year and next year. My forecast is predicated on fed funds rate increases that begin in December of this year, gradually bringing the funds rate to 4¼ percent in 2010. She actually expected that a tightening cycle would be inaugurated at the time the FOMC was instead going full-blown ZIRP. Why? To them the crisis had been wrapped up essentially with the advent and operational implementation of multiple “emergency” liquidity programs. HOENIG More broadly, turning to the national economy, I have revised up my growth estimate for the first half of 2008, but it has made little change in my longer-run outlook. Compared with the Greenbook, I see somewhat stronger growth in the second half of this year and somewhat weaker growth next year and in 2010. I continue to judge that the potential spillover effects from the financial distress have understandably been overestimated in this Committee’s recent decisions and in Greenbook forecasts in recent months. LACKER On the whole, I think the risk of the national economy sinking into a serious recession has receded, and the growth outlook has edged up a bit. I was relieved by the strength in retail sales in May as well as the upward revisions for April and March. The ISM indexes have steadied at right around 50 over the past four months; and although the labor market has been weak, it has not yet shown the accelerating declines that I feared. President Plosser’s comments below immediately follow Eric Rosengren’s more cautious warning that, “I continue to view the downside risk of further financial shocks as being significant.” No one in the meeting followed that line of inquiry, including Rosengren himself. PLOSSER From the financial side, credit spreads have fallen, bond issuance has risen, and it appears that financial market functioning has at least improved. In my view, although downside risks to growth remain, the tail risk of a very bad outcome has clearly been diminished. PLOSSER Given recent economic developments and the improvement in financial market functioning, coupled with our accommodative stance of policy, it seems pretty clear to me that, if the economy continues to evolve as it has over the past couple of months, we should move to raise the funds rate. This is also the view of market participants, whose expectations for policy have steepened considerably over the intermeeting period. He joined Yellen’s prediction that the federal funds rate would be back to something above 2.75% by the end of 2008 (as a reminder, the federal funds target rate remains 0%-0.25% almost six years later). The combination here is one of linear thinking and abundant optimism, not about the economy, per se, but about their own ability to control it all. Instead of linking that with time and systemic processing, they mistook it for a condition that their fears would never be realized. In other words, because they had acted and nothing worse had occurred by June, they saw those actions as the very reason for it. More troubling, they extrapolated that those programs were comprehensive and would thus forestall any possibility of eventually realizing those worst fears (in the end, what actually occurred ended up being worse than those worst case expectations). YELLEN The aggressive policy actions that we have put in place since January are actually working to cushion the blow, and that’s part of the reason that we haven’t seen a greater unraveling so far. BULLARD Recent data on the U.S. economy have been stronger than forecast, keeping economic performance weak but avoiding a particularly sharp contraction. The worst outcomes stemming from financial market turmoil have failed to materialize thus far. There is, to be sure, still some potential for additional upheaval, depending in part on the managerial agility among key financial firms. However, the U.S. economy is now much better positioned to handle financial market turmoil than it was six months ago. This is due to the lending facilities now in place and to the environment of low interest rates that has been created. Renewed financial market turmoil, should it occur during the summer or fall, would not now be as worrisome from a systemic risk perspective. President Bullard was speaking directly to their experience with, and “successful” handling of, the Bear Stearns collapse. He added later: BULLARD Systemic risk is in part a function of the degree of surprise in the failure of a financial institution that was perceived to be in good health. Surely by now few market participants would be surprised to encounter the failure of certain institutions. Failures, should they occur, can be handled in an orderly way. Certain investors would lose out in such an event, to be sure, but my sense is that the panic element that would be associated with systemic risk would not be present. I believe that we should start to downweight systemic risk concerns substantially going forward because it is no longer credible to say that market participants are surprised to learn of problems at certain financial institutions. His meaning here is plain, if somewhat coded. The idea, echoed throughout that meeting, was that the FOMC had provided the template for any future liquidity episodes, thus there should be no more panic because “everything” had been revealed by that point. The implications of that, for President Bullard, were: BULLARD U.S. economic data have been stronger than expected during the intermeeting period. The earlier, very aggressive moves in January and March taken by the FOMC were viewed in part as insurance against the possibility of a very serious downturn brought on by financial market turmoil. That very serious downturn has not materialized. Tail risk has diminished significantly. This means that this Committee has put too much economic stimulus on the table and must think about ways to remove it going forward. Again, the sentiments were unambiguous, through Yellen, Plosser, Bullard and the rest. Lest anyone think I am overstating this focus, Governor Kohn leaves no doubt by actually vocalizing exactly this linear thinking. KOHN I myself have been very surprised—I will be very open about this—at the persistence, the extent, the depth, and the spread of this crisis and how long it went and what it covered. Every couple of months, I thought it was about to be over, and then another wave would come. I think that we have learned something about the financial system in the process, and we have learned that the regulatory structure and the liquidity provision structure were not sufficient to give the economy the protection it needed from the new style of financial system. That is really the background of why we are here, not just because we made the loan or we set up the facilities because we thought we needed to do so to protect the system under the circumstances. Apparently they did not “learn something about the financial system”, at least not the right lessons. At each ebb in the trajectory, they really thought it represented the end; only to be surprised over the doggedness at which the system refused such benighted assistance. That betrays not just overconfidence but a basic inability to see the system in its actual condition, even to the point of misreading what were really clear market signals. Again, this was June 2008, late June at that, when stock prices had resumed their slump and credit spreads widened once more. Against that backdrop, their linear thinking led to the conclusion below, voiced by President Lacker, supported by every model in the Fed’s arsenal (the Greenbook contains numerous simulations) and further echoed by “private” economic surveys and estimates. LACKER Despite all of these elements that could depress growth, I think the economic situation has undoubtedly turned out better than we expected at the April meeting because of the better-than-expected consumer and business-investment numbers. Greenbook now forecasts a period of low but positive real growth, significantly better than the experiences of the last two fairly mild recessions, and I think that is about right. Yes, the expectation of the “best and brightest” was for a “significantly better” outcome as compared to the ridiculously minor dot-com recession and the slightly more serious recession in 1990-91. Common sense would have overridden such incongruity – that there would be much less economic impact from an actual bout of bank runs, collateral chain depression and credit withdrawal turning against housing on an unprecedented scale than what came during Greenspan’s housing bubble solution? As I stated when the 2008 transcripts were finally released, these actual policymaking discussions should disqualify not only the FOMC members but discredit the entire philosophy from the ground up. How can you conclude otherwise? And the relevance here to our current circumstance is obvious, not the least of which given Janet Yellen’s ascendancy. Does anyone honestly believe that anything has changed? It wasn’t just that they missed the timing or proffered the wrong policy mix, it was a fundamental and deep misunderstanding of almost everything in and about finance and economics, including especially the relations between the two. The net result was exactly as we see right now – an overestimation of their abilities to control and manage, owing to this lack of grounded understanding, leading to persistent over-optimism about the economy. As if to remove all doubt, the current FOMC just replayed the June 2008 “ebb” period by again taking a temporary bump in GDP and other factors and translating that in linear fashion to some durable acceleration, rather than the hollow inventory trend that is being steadily revealed. If they couldn’t see recession at the end of June 2008, when might they ever?

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