From Financial Markets to Inflation Fears

By spring 2008, then, the FOMC had managed to make the connection between housing and financial markets that they had missed at the start of the deteriora­tion in the performance of nonconventional mortgages.

Dallas Reserve Bank president Richard Fisher spelled out this shift in empha­sis at the April 29-30 meeting: “While there are many who have voiced concern with the adverse feedback loop that runs from the economy to tighter credit con­ditions and back to the economy, I am very troubled by a different adverse feed­back loop—namely the inflation dynamic whereby restrictions in the fed funds rate lead to a weaker dollar and upward pressures on global commodity prices, which feed through to higher U.S. inflation.” Fisher concluded, “I believe the risk posed by inflation is more significant than the extension of further anemia in the economy” (FOMC, 2008c: 54).

Some participants even began to suggest parallels with the inflation environ­ment of the 1970s. As Plosser warned in April 2008, “In the 1970s one of our mistakes was that we accommodated relative price shocks with very accommo­dative monetary policy, and in so doing helped convert a relative price shock into sustained inflation. I think we should be careful not to fall into that same trap” (FOMC, 2008c: 107-108).

To be sure, such claims were a source of conflict. Relative to the high levels of consensus that characterized the FOMC during much of our time frame, the spring and summer of 2008 represented a period of contestation.

Broadly speaking, the board of governors, along with the New York, Boston, and San Francisco Reserve Bank presidents, exhibited comparatively greater concern for financial markets and growth during this period, while most of the remaining presidents stressed commodity prices and inflation. Of course, the former group exercised decision-making power, although the latter was numer­ically stronger and thus dominated discussion if not policy. Even official FOMC statements, however, maintained from April 2008 onward that inflation had reemerged as a risk roughly equaling the risks to growth. At least one mem­ber of the board, Kevin Warsh, went further. Warsh insisted on August 5, 2008, “My view is that inflation risks are very real, and that these risks are higher than growth risks” (FOMC, 2008d: 84).

Thus, a mere forty days before the failure of Lehman Brothers and ensuing stock market free fall, many participants maintained that the risks of financial collapse were no longer the committee's major concern. Making standard ref­erence to the economy's “resilience,” Chicago Reserve Bank president Charles Evans summarized a widely held viewpoint as of early August: “One year on the economy has withstood the financial shock in a resilient fashion, especially giv­en the add-on shock from oil. I don't know what more we could have hoped for from the vantage point of the fall of 2007” (FOMC, 2008d: 107).

Indeed, the FOMC was hesitant to abandon this position even after Lehman Brothers filed for bankruptcy on September 15, 2008, the largest such filing in US history. On the following day, at the regularly scheduled FOMC meeting, partic­ipants by and large downplayed the significance of the Lehman failure and the financial market turmoil it was causing.

While a lot of attention in the short run is being paid to financial markets' turmoil, our decision today must look beyond today's financial markets to the real economy and its prospects in the future. In this regard, things have not changed very much, at least not yet............. I agree that recent finan­

cial turmoil may ultimately affect the outlook in a significant way, but that is far from obvious at this point. (FOMC, 2008e: 38)

Richmond Reserve Bank president Lacker concurred: “Overall, I don't take what's happened in the last few days as changing much. It's not obvious to me what the implications are for the outlook for inflation and growth, at least at this point” (FOMC, 2008e: 48).

Many participants simply reasserted the inflation narrative of previous months. Indeed, they expressed concerns that the visibility of short-term finan­cial events would distract the FOMC from its commitment to long-term price stability. For instance, Thomas Hoenig, Kansas City Reserve Bank president, im­plored the committee “to look beyond the immediate crisis, which I recognize is serious. But as pointed out here, we also have an inflation issue” (FOMC, 2008e: 31). Strikingly, the FOMC policy statement released on September 16, 2008, and presented at the beginning of this chapter continued to suggest that the risks to growth and inflation were roughly equal.

Not all reactions to the Lehman bankruptcy were so sanguine. Boston Re­serve Bank president Eric Rosengren insisted otherwise at the September 16 meeting: “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” (FOMC, 2008e: 30).

Of course, all of this would change in a matter of days (Abolafia, 2020). On September 29, 2008, the FOMC held an emergency meeting on the phone. At this meeting, Chair Bernanke announced that the Federal Reserve had taken three actions in the face of what was looking like a collapse of not only the US but also the world's financial markets (FOMC, 2008f: 1-4). He proposed to open the credit window to any bank that had a US presence, including foreign banks, in order to provide them with short-term liquidity. He also explained that he was expanding short-term credit swaps with most of the largest central banks in the world. He explained that the coordination of this effort was to give a signal to markets that the central banks would make sure there was sufficient liquidity in the markets that banks could borrow and survive. Finally, he reported on the first version of what became the Troubled Assets Relief Program (TARP).

The situation did not get any better in the next two weeks. Chair Bernan­ke called another emergency phone meeting of the FOMC on October 7, 2008. At this meeting, he explained to the members of the committee that six central banks had agreed to coordinate a 0.5 percent interest rate cut in order to display to banks around the world that the central banks were serious about providing credit for the world economy (FOMC, 2008g: 1-3). Chair Bernanke needed to persuade the members of the FOMC to go along with this tactic. After a short discussion, the committee voted unanimously to lower interest rates.

In their press release the next day, the FOMC explained,

The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1 / 2 percent.

Incoming econo mic data suggest that thepaf e of economic activity has slowed markedly in recent months. Moreover, the intensification of finan­cial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain cred­it. Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation. (FOMC, 2008h: 2)

By the next regularly scheduled meeting, on October 28-29, Janet Yellen was arguing that “we are in the midst of a serious global meltdown” (FOMC, 2008i: 68). Her fellow FOMC members agreed. The events that followed included the passage of the TARP and the reorganization of the largest banks. The main goal was to provide massive liquidity for banks that could survive and to march those who were insolvent into reorganization, merger, or bankruptcy in an orderly and rapid fashion. The actions of Chair Bernanke and the Federal Reserve to en­gage in these policies and aggressively lower interest rates and coordinate actions with international authorities probably prevented what would have been a much worse crisis. These policy decisions have been widely documented (see especially Blinder, 2013; Eichengreen, 2015).

Nonetheless, we can safely conclude that at no point prior to the last months of 2008 did the FOMC even remotely appreciate the depths or dangers of the financial crisis. Even after they came to grasp that housing and financial markets were intimately intertwined, they failed to recognize the extent of the risk that housing posed for financial markets and institutions. What is more, they failed to recognize the extent of the risk that financial markets and institutions posed for economic growth. In short, the FOMC continued to make sense of economic life in terms of two conceptually distinct and largely independent spaces: the “financial” and the “real” economies.