Fed didn't see it coming


The day after Lehman Brothers Holdings Inc. declared the largest bankruptcy in U.S. history in 2008, Federal Reserve officials remained unsure whether the financial crisis would do lasting damage to the U.S. economy.

“I don’t think we’ve seen a significant change in the basic outlook,” Dave Stockton, the Fed’s top forecaster, said on Sept. 16, 2008 according to transcripts released today in Washington. “We’re still expecting a very gradual pickup in GDP growth over the next year.”

The records show Fed officials struggling to understand the magnitude of the financial crisis that was underway, and the potential fallout for the economy. The unemployment rate jumped to 6.1 percent in August from 5 percent at the start of the year, even as inflation was also rising.

The financial crisis would lead to a credit freeze that helped push the unemployment rate up as high as 10 percent. By 2009, more than 15 million Americans would be out of work.

At the September meeting, officials discussed the collapse of Lehman, yet left their main interest rate at 2 percent, rebuffing calls by some investors for an immediate cut.

“I don’t really have anything useful to say about the economic consequences of the financial developments of the past few days,” Stockton said. “I must say I’m not feeling very well about it at the present, but I’m not sure whether that reflects rational economic analysis or the fact that I’ve had too many meals out of the vending machines downstairs in the last few days.”

Growing Strains

The Fed signaled it would consider a rate cut in the future by acknowledging, in its statement, growing strains in financial markets. Policy makers also said employment was weakening and export growth slowing, and they dropped a reference to elevated inflation expectations.

“Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters,” the FOMC said in its statement.

Janet Yellen, then president of the San Francisco Fed, amused her colleagues by relaying anecdotal reports of cutbacks in discretionary spending.

“East Bay plastic surgeons and dentists note that patients are deferring elective procedures,” Yellen said to laughter, according to the transcripts. Yellen became Fed vice chair in 2010 and succeeded Ben S. Bernanke as chair earlier this month.

Labor Markets

On a more somber note, Yellen said that labor markets “are weakening across the board” and “the interaction of higher unemployment with the housing and financial markets raises the potential for even worse news -- namely, an intensification of the adverse feedback loop we have long worried about and are now experiencing.”

Still, when it came time to vote, Yellen joined the majority in favor of holding rates at 2 percent.

Officials had earlier taken quick action as the economic outlook deteriorated, cutting the federal funds rate from 4.25 percent at the start of the year, when Yellen had warned that the nation was on the “brink of recession.”

By September, the monetary policy response, along with the emergency liquidity facilities for financial markets, were seen as adequate for handling the strains in the economy.

“I think our aggressive approach earlier in the year is looking pretty good,” Bernanke said. Even so, he said it was likely that the country was already in a recession, and “I think we are in for a period of quite slow growth.”

Fannie Mae

In addition to the collapse of Lehman Brothers, the U.S. government had seized control of Fannie Mae and Freddie Mac, the largest U.S. mortgage-finance companies, on Sept. 7.

Some policy makers in September continued to see inflation as the primary risk to the economy.

“I also encourage us to look beyond the immediate crisis, which I recognize is serious,” said Thomas Hoenig, then president of the Kansas City Fed. “But as pointed out here, we also have an inflation issue.”

James Bullard of St. Louis said that he took comfort from the Fed’s experience in March, when the investment bank Bear Stearns Cos. collapsed.

“Financial-market turmoil is certainly a key concern, but the U.S. economy still outperformed expectations in the first half of 2008, despite the demise of Bear Stearns,” said Bullard, who described it as “an event not too different in some respects from the current episode.”

The decision to hold the federal funds rate at 2 percent was unanimous among the committee’s voters. Fed presidents have rotating votes on monetary policy, and Boston Fed President Eric Rosengren, who didn’t vote that year, favored easing.

“This is already a historic week, and the week has just begun,” he said. “I am not convinced that the unemployment rate will level off” as the Fed board had forecast.

“The failure of a major investment bank, the forced merger of another, the largest thrift and insurer teetering, and the failure of Freddie and Fannie are likely to have a significant impact on the real economy.”

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