Economic growth appears to have slowed recently, partly reflecting a softening of household spending.

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. Over time, the substantial easing of monetary policy, combined with ongoing mea­sures to foster market liquidity, should help to promote moderate eco­nomic growth.

—federal open market Committee Statement, September 16, 2008

The Federal Open Market Committee of the Federal Reserve is charged with making monetary policy for the United States. It is also one of the major eco­nomic forecasters for the US government. As such, its meetings (about every six weeks) are widely watched by participants in the financial markets for clues regarding the future trajectory of the economy (Holmes, 2014). The Feder­al Reserve and the Federal Open Market Committee (hereafter, FOMC) are among the leading players in formulating policy responses in when a financial crisis is brewing. On September 16, 2008, the day after the investment bank Lehman Brothers collapsed, precipitating the largest financial meltdown in postwar history (Swedberg, 2010), members of the FOMC met and issued the above statement.

Why was the FOMC so sanguine in its economic projections? Even though they recognized the distress being caused by the drop in home prices, the rise in foreclosures, and the increasing problems for financial institutions that held MBSs and CDOs, the FOMC consistently underestimated the risks to the econo­my during the months and years that preceded the financial crisis of 2007-2008.

Second, we know that the dynamic of meetings often leads participants to downplay uncomfortable facts and try to find a positive spin to whatever chal­lenge they face (Cerulo, 2006; Turner, 1976; Vaughan, 1996; Zerubavel, 2015). The FOMCs misperception of the financial crisis was a function of organizational and cultural tendencies to ignore and normalize discordant information (Ceru- lo, 2006; Turner, 1976: Vaughan, 1996; Zerubavel, 2015). This is particularly true in contexts where the information is incomplete and sometimes contradictory and the right thing to do is not obvious. Members of the FOMC operate in a highly opaque world. Indeed, their job is to examine fragmentary evidence and come to a prediction about the near future. As I will show in this chapter, this led members of the FOMC to use whatever data they had to generally offer positive stories in the face of data that seemed to suggest worst-case scenarios.

Any framework a group uses to understand the world operates as a filter through which a group understands its world (Diehl and McFarland, 2010; Goffman, 1974; Weick et al., 2005; Weick, 1988; Starbuck and Milliken, 1988). This filtering helps groups arrive at decisions by focusing arguments around constructing a coherent narrative. But by its very nature, any way of looking at things highlights certain facts while excluding others. This makes it difficult or impossible to see facts that are inconsistent with a group's prior beliefs and easy to downplay them, whatever those beliefs are. But group interaction is difficult or impossible without a shared framework and set of assumptions that can be used for discussion and settlement.

The actual cultural content of a framework helps explain the substance of what a source of risk is (Weick, 1988). The FOMC failed to see the depth of the problems in the housing and financial sectors because of its overreliance on mac­roeconomics as the frame it used for making sense of the economy. Participants adhered to a version of macroeconomic theory and modeling that had achieved high consensus among academics and central bankers alike by the early 2000s— the so-called “new neoclassical synthesis” (Goodfriend and King, 1997; for its use at the Federal Reserve, see Brayton et al., 1997; Goodfriend, 2007). Consis­tent with modern macroeconomic reasoning, FOMC participants believed that the large and complex American economy could be successfully understood in terms of a small number of aggregate-level indicators such as the inflation rate, the unemployment rate, productivity, and growth in GDP (for the privileging of parsimony in modern macroeconomics, see Solow, 2008).

The most important implication of this perspective is that macroeconomic theory views finance as just one sector of the economy, one that was unlikely to cause spillovers to other sectors that could affect economic growth in a dramatic way. Specifically, the FOMC failed to see the importance of housing-related fi­nancial instruments in fueling the economy. In fact, the financial industry was producing $4 trillion in mortgages and nearly 40 percent of the profits in the entire economy by 2003 (Fligstein and Goldstein, 2010). When mortgages began to fail, the financial instruments built on them began to lose value as well. Banks who had borrowed money to finance their holdings began to collapse. In the fall of 2008, this caused financial markets in the United States to freeze and made it difficult for anyone to borrow or lend. What made the downturn in housing so fundamentally destabilizing to the economy was the size of the market combined with the connection of that market to the largest investments that banks had.

Most readers will not find it surprising that the FOMC focused on macroeco­nomic analysis as its main tool for framing and justifying its actions. But there are several reasons why this overreliance on macroeconomics is curious. One of the central missions of the Federal Reserve is to regulate the financial system. As such, the Federal Reserve is understandably concerned with financial stability. After all, any threat to that stability would spill over to the rest of the economy and produce a serious recession. Hence, it might be expected that a certain at­tention would be paid to the stability of the relationship between the providers of finance and its consumers. If the FOMC had been dominated by such a perspec­tive, it might have been more cognizant of how the banking system, not just in the United States but in western Europe as well, had become overinvested in the housing market. This was made worse by using borrowed money from the ABCP market that needed to be paid back or rolled over in less than a year, making them vulnerable to a housing downturn.

Moreover, the FOMC's policymaking orientation is toward the financial mar­kets, the providers of equity and debt for the economy, which the FOMC views as the primary audience for its pronouncements (Holmes, 2014). There is a great deal of discussion at the meetings of the FOMC about what is going on in the financial markets. Such an orientation could have directed the FOMC to orient its conceptual focus toward the important role the financial sector had come to play in the economy. But instead, the FOMC focused on the stock market and bond prices and did not pay much attention to the underlying investment strat­egies of the largest market players.

The main evidence used in this chapter is the presentation of representative opinions from the detailed transcripts of FOMC meetings that took place be­tween 2002 and 2008.¹ In particular, I consider two periods in the FOMC delib­erations in order to support my points about why the Federal Reserve did not see the severity of the crisis. First is the degree to which the FOMC saw that there was or was not a housing price bubble in the American economy from 2001 to 2005. In the summer of 2005, the FOMC held a meeting devoted specifically to considering whether there was a housing price bubble and, if so, what they might do about it. While some participants emphasized the link between finance and the broader economy and its attendant risks, they were in a very small minority. For the most part, the members of the FOMC downplayed the existence of a bubble and underestimated its effects on the rest of the economy, drawing ex­plicitly on macroeconomic theory for support. They concluded that the macro­economic effects of the bubble bursting (which many of them doubted existed) would not be that large. This case illustrates how the FOMC tended toward a positive viewpoint on possible troubles in the economy and how the frame of macroeconomics reinforced that bias.

Then, I consider how the FOMC interpreted the initial period of the finan­cial crisis from 2006 that culminated in the bankruptcy of Lehman Brothers in September 2008 (captured in the quote at the beginning of this chapter). The FOMC was well aware of the crisis in home foreclosures and later of the prob­lems of financial institutions. But I show that the macroeconomic framing led many members of the FOMC to underestimate the peril presented by the finan­cial crisis. They never articulated the close link between the size of the housing market, its shift to nonconventional mortgages, the financial instruments that now were the largest investment of most of the big banks, and the high degree of credit that banks were using to fund those investments. Instead, as the quotation at the top of this chapter shows, their macroeconomic perspective had many of the members of the FOMC emphasizing their ongoing concern with inflation in September 2008, an issue at the heart of macroeconomic theory and central to the role of the Federal Reserve in the economy.