Matthew O’Brien at The Atlantic has written a marvelous account of the bizarre deliberations of the Federal Open Market Committee at its meetings (June 25 and August 5) before the Lehman debacle on September 15 2008 and its meeting the next day on September 16. A few weeks ago, I wrote in half-seriousness a post attributing the 2008 financial crisis to ethanol because of the runup in corn and other grain prices in 2008 owing to the ethanol mandate and the restrictions on imported ethanol products. But ethanol, as several commenters pointed out, was only a part, probably a relatively small part, of the spike in commodities prices in the summer of 2008. Thanks to O’Brien’s careful reading of the recently released transcripts of the 2008 meetings of the FOMC, we now have a clear picture of how obsessed the FOMC was about inflation, especially the gang of four regional bank presidents, Charles Plosser, Richard Fisher, James Lacker, and Thomas Hoenig, supported to a greater or lesser extent by James Bullard and Kevin Warsh.
On the other hand, O’Brien does point out that two members of the FOMC, Eric Rosengren, President of the Boston Fed, and Fredric Mishkin of the Board of Governors, consistently warned of the dangers of a financial crisis, and consistently objected to and cogently punctured the hysterical inflation fears of the gang of four. It is somewhat, but only somewhat, reassuring that Janet Yellen was slightly more sensitive to the dangers of a financial crisis and less concerned about inflation than Ben Bernanke. Perhaps because he was still getting his feet wet as chairman, Bernanke seems to have been trying to articulate a position that could balance the opposing concerns of the FOMC membership, rather than leading the FOMC in the direction he thought best. While Yellen did not indulge the inflation phobia of the gang of four, she did not strongly support Rosengren and Mishkin in calling for aggressive action to avert the crisis that they clearly saw looming on the horizon.
Here are some highlights from O’Brien’s brilliant piece:
[FOMC Meeting] June 24-25, 2008: 468 mentions of inflation, 44 of unemployment, and 35 of systemic risks/crises
Those numbers pretty much tell you everything you need to know about what happened during the disastrous summer of 2008 at the Fed
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.”
In short, inflation was high today, but it wouldn’t be tomorrow. They should ignore it. A few agreed. Most didn’t.
Mishkin, Fed Governor Donald Kohn, and then-San Francisco Fed chief Janet Yellen comprised Team: Ignore Inflation. They pointed out that core inflation hadn’t actually risen, and that “inflation expectations remain reasonably well-anchored.” The rest of the Fed, though, was eager to raise rates soon, if not right away. Philadelphia Fed president Charles Plosser recognized that core inflation was flat, but still thought they needed to get ready to tighten “or our credibility could soon vanish.” Fed Governor Kevin Warsh said that “inflation risks, in my view, continue to predominate as the greater risk to the economy,” because he thought headline would get passed into core inflation.
And let us not forget Richard Fisher of the Dallas Fed who provided badly needed comic relief.
And then there was 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. [Laughter]
But it was another member of the Gang of Four who warned ominously:
Richmond Fed president Jeffrey Lacker suggested, that “at some point we’re going to choose to let something disruptive happen.”
Now to the August meeting:
[FOMC Meeting] August 5, 2008: 322 mentions of inflation, 28 of unemployment, and 19 of systemic risks/crises.
Despite evidence that the inflationary blip of spring and summer was winding down, and the real economy was weakening, the Gang of Four continued to press their case for tougher anti-inflation measures. But only Rosengren and Mishkin spoke out against them.
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.” In other words, inflation would come down on its own, and the Fed should focus on the credit crunch instead. 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.
But Richard Fisher was in no mood to worry about horror stories unless they were about runaway inflation:
The hawks didn’t want to wait. 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.” He wanted the Fed to “be prepared to raise rates even if growth is not back to potential, and even if financial markets are not yet tranquil.” In other words, to fight nonexistent wage inflation today to prevent possible wage inflation tomorrow, never mind the crumbling economy. Warsh, for his part, kept insisting that “inflation risks are very real, and I believe that these are higher than growth risks.” And Fisher had more”chilling anecdotes”—as Bernanke jokingly called them—about inflation. This time, the culprit was Disney World and its 5 percent price increase for single-day tickets.
The FOMC was divided, but the inflation-phobes held the upper hand. Unwilling to challenge them, Bernanke appeased them by promising that his statement about future monetary policy after the meeting would be “be slightly hawkish—to indicate a slight uplift in policy.”
Frightened by what he was hearing, Mishkin reminded his colleagues of some unpleasant monetary history:
Remember that in the Great Depression, when—I can’t use the expression because it would be in the transcripts, but you know what I’m thinking—something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock.
Mishkin also reminded his colleagues that the stance of monetary policy cannot be directly inferred from the federal funds rate.
I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. I’m holding two houses right now. I’m very nervous.
And now to the September meeting, the day after Lehman collapsed:
[FOMC meeting] September 16, 2008: 129 mentions of inflation, 26 of unemployment, and 4 of systemic risks/crises
Chillingly, Lacker and Hoenig did a kind of victory dance about the collapse of Lehman Brothers.
Lacker had gotten the “disruptive” event he had wanted, and he was pretty pleased about it. “What we did with Lehman I obviously think was good,” he said, because it would “enhance the credibility of any commitment that we make in the future to be willing to let an institution fail.” Hoenig concurred that it was the “right thing,” because it would suck moral hazard out of the market.
The rest of the Gang of Four and their allies remained focused like a laser on inflation.
Even though commodity prices and inflation expectations were both falling fast, 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 was heartened by falling commodity prices, but said, “I remain concerned about the inflation outlook going forward,” because “I do not see the ongoing slowdown in economic activity is entirely demand driven.” And Fisher half-jokingly complained that the bakery he’d been going to for 30 years—”the best maker of not only bagels, but anything with Crisco in it”—had just increased prices. All of them wanted to leave rates unchanged at 2 percent.
Again, only Eric Rosengren seemed to be in touch with reality, but no was listening:
[Rosengren] was afraid that exactly what did end up happening would happen. That all the financial chaos “would have a significant impact on the real economy,” that “individuals and firms will be become risk averse, with reluctance to consume or invest,” that “credit spreads are rising, and the cost and availability of financing is becoming more difficult,” and that “deleveraging is likely to occur with a vengeance.” More than that, he thought that the “calculated bet” they took in letting Lehman fail would look particularly bad “if we have a run on the money market funds or if the nongovernment tri-party repo market shuts down.” He wanted to cut rates immediately to do what they could to offset the worsening credit crunch. Nobody else did.
Like Bernanke for instance. Here is his take on the situation:
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.
OMG!
O’Brien uses one of my favorite Hawtrey quotes to describe the insanity of the FOMC deliberations:
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.
It brought to mind what economist R. G. Hawtrey had said about the Great Depression. Back then, central bankers had worried more about the possibility of inflation than the grim reality of deflation. It was, Hawtrey said, like “crying Fire! Fire! in Noah’s flood.”
In any non-dysfunctional institution, the perpetrators of this outrage would have been sacked. But three of Gang of Four (Hoenig having become a director of the FDIC in 2012) remain safely ensconced in their exalted positions, blithely continuing, without the slightest acknowledgment of their catastrophic past misjudgments, to exert a malign influence on monetary policy. For shame!
Uneasy Money 
Great post. Are there some words missing from the last sentence of your first paragraph?
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David,
An observation: despite the title, the post is a long way from establishing causality.
Yes, there was some Fed inaction. Was it a causal factor? There is an argument to be made that only by backstopping the liabilities of the shadow banking system could the Fed have prevented the panic. It basically did this a month later. To have done it in September would have been next to impossible.
Gorton describes how the “panic of 2008” was an ongoing, classic run on the liabilities of the shadow banking system that actually began in 2007. By September, during a mild recession, AAA security downgrades were widespread: a seemingly impossible occurrence. It was these downgrades that called into question the “information insensitivity” of shadow banking liabilities. Lehman was just a milestone on the road to a classic lemons problem, and the way to prevent a lemons problem is for the Fed to exercise its role as lender of last resort. So maybe the post could have explained how the Fed could have pulled that off in September of 2008 without precipitating yet more of an increase in systemic risk. This is what the Bear Strearns bailout arguably accomplished back in March.
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David,
This is an amateur question, but could you briefly state the precise mechanism through which such contractionary policy would have crashed Lehman and the financial sector. What is the mechanism through which contractionary monetary policy causes banking crises? In the words of Stephen Williamson, what’s your model?
And is the mechanism that occurred in 2008 the same one that occurred in 1930ish?
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Thanks for adding the missing words.
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David, Thanks, and yes there were some missing words, which I have now inserted.
Diego, My argument (which you are correct to point out is not fully spelled out in this post) is not that the Fed could have done anything at its September meeting that would have prevented the panic. My point is to show that the Fed completely misunderstood the nature and severity of the crisis that was brewing and that this obliviousness to reality was caused by a pathological obsession with an inflationary blip in the spring and summer of 2008 that had nothing to do with monetary policy. If the FOMC had not been so disconnected from reality as to ignore the sound advice of Eric Rosengren, there is a decent chance, but no certainty to be sure, that panic could have been avoided or mitigated.
The economy was not in a mild recession in September 2008 before Lehman crashed. The contraction in the third quarter was one of the sharpest in the postwar period, and unemployment was increasing very rapidly in 2008. The Fed should have been easing all through 2008. Instead, the monetary base was almost flat. I haven’t had a chance to search for it in the transcript, but my recollection is that the Fed was very pleased with itself in the summer of 2008, because the dollar was rapidly appreciating against the euro and other currencies, which was another sign that the Fed was in the process of asphyxiating the US economy.
Ilya, The mechanism I think is simple. Contractionary monetary policy reduces total spending and income. Debts are fixed in nominal terms. Contracting nominal income implies that fewer debts fixed in nominal terms will be repaid. See my post on Hawtrey’s account of financial crises in Good and Bad Trade.
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To say that the monetary base was essentially flat is pretty accurate. From the beginning of 2005 to the week of September 17, 2008 (more than 3 and a half years), the base increased by 13.6%. Between the beginning of 2008 and the week of September 17, the increase was 4.4%. And it’s worth recalling that the NBER has dated the beginning of the recession to December 2007. Meanwhile, the total increase in the core PCE index from January 2005 to September 2008 was 8.1%–well below 3% per year. The increase from September 2007 to September 2008 was a whopping 2.1%. And falling. (All data from the St. Louis Fed’s FRED data set.)
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Diego, I don’t read the post as being an expose on causation, but rather an observation that to err is human, but when the error is so damaging to so many there should be consequences. Especially if these same actors are in a state of denial. I think the last paragraph of the post really says it all. If I have any criticism of the post, it is that the last paragraph should have been the opening paragraph. It is scary to think that one of a handful of unelected people who have so much control over the largest economy in the world bases his arguments for a course of action on silly anecdotal based beliefs and examples. It’s like saying my neighbor bought a green car therefore everyone is going to be buying a green car. This will cause the price of green paint to skyrocket which will lead to high inflation in every sector of the economy. Disneyland tickets, Budweiser, Fritos, dry cleaning in Dallas? Seriously, this is how decisions are made at the Fed? It would be funny if it wasn’t so sad.
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Great blog on a great article.
I sorted through the transcripts too, and what I noted was how rarely unit labor costs mentioned—maybe a half dozen times—vs inflation and commodities, which as you can see, were mentioned hundreds of times.
A Fed staffer told the FOMC to expect until labor costs to rise at a 2 percent annual rate going forward, in the June meeting.
Actually,unit labor costs have risen 1.7 percent since the first quarter—of 2007 that is. That’s not annually compounded, that’s total. Perhaps the Fed staffer meant to say “We expect unit labor costs to rise by 0.2 percent annually.”
Over at Scott Sumner’s blog, some of the commenters expressed frustration that transcripts are secret for so long—that limits feedback that could be valuable in policy making. For my part, I see no reason why FOMC meetings are not broadcast on CSPAN. Open and transparent government is always the first choice.
If someone ever says a government meeting should be behind closed doors, the onus is on that person. So what is the justification for secret FOMC meetings?
It is clear that some sort of inflation-hysteria has become the cultural norm at the Fed, and that as a independent public agency,it is an organization ossifying, secluded, and cloistered.
And let’s face it: Your entrepreneur, your real estate developers or manufacturing guys are not going to sign up to be Fed staffers. The FOMC board has no labor reps on it. We are paying the price for the Fed’s divorce from the rough-and-ready world.
Fed staffers and board members actually believe inflation of more than 1.5 percent is a horror, worse than a prolonged recession. If you do not believe that, then read some of Richard Fisher’s speeches.
We will see how Janet Yellen does. She is tapering in the face of falling inflation and a so-so economy. Not a great start.
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David, did you see Krugman’s response?
http://krugman.blogs.nytimes.com/2014/02/28/did-inflation-phobia-cause-the-great-recession/?_php=true&_type=blogs&_r=0
Benjamin, I think it’s more than just a few staffers and board members that are frightened of anything more than 1.5% inflation: I would not be surprised in the least if there wasn’t a large, vocal, angry, suspicious (bordering on paranoid), possibly gun-toting, segment of the population that feels exactly the same way (Remember when Rick Perry suggested that Bernanke might get treated “pretty ugly” if he were to show his face in Texas because he was “printing too much money?”).
I think it was Don Gedis at Sumner’s who surmised that for a lot of people, 2% inflation shouldn’t really be a target, they grudgingly accept that as an upper bound, so anything less than that and they feel like it’s even better! I suspect he might be right!
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David, O/T: there seem to be a discussion brewing between Nick Rowe, Roger Farmer, Mark A. Sadowski, Scott Sumner, and Mike Sax regarding the originality of Keynes’s contribution to macro, specifically the concepts of AS and AD:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/02/keynes-gt-chapter-3.html?cid=6a00d83451688169e201a3fcc986c7970b#comment-6a00d83451688169e201a3fcc986c7970b
http://diaryofarepublicanhater.blogspot.com/2014/02/bernanke-on-origins-of-macroeconomics.html?showComment=1393619948687#c5694216381071256062
I figured you might know something about that.
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got one in moderation re: Keynes’ contribution.
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David, Great post. Shall we start calling the Sept 2008 meeting the “Noah’s flood” meeting?
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Thanks, Scott. Sure, but I think you could call all three meetings (June, August and September) Noah’s flood meetings. Did you see Krugman’s post on Friday?
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David,
Two more questions.
First, is the mechanism you describe the same as Fisher’s debt-deflation theory?
Second, I’m curious what your response would be to Krugman’s post on this. And also, what sort of research could be done to verify if your theories and that of Sumner’s are correct?
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David,
As an fyi 2004 sub prime assets – the best vintage in terms of quality – lost 62% of their value between October 2007 and August 2008. The 2007 vintage lost 77% of their value between these dates. The Lehman default had a limited impact on the value of sub prime securities. The dramatic fall in asset values prior to August 2008 did most of the damage to Lehman’s (off) balance sheet. I’ve not read the transcripts but I suspect there was not a lot of discussion on the impact of falling credit derivative values on the solvency of the banking sector. The more interesting question to me is therefore whether flooring interest rates earlier on would have propped up house prices or not.
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Don, Thanks for checking. Actually, I would break it up a bit differently. The monetary base in 2007 increased by about 1%. From the beginning of 2008 to September 10, the monetary base increased by 3.1%. The demand for money usually increases in a recession, so the increase in the monetary base in 2008 does not necessarily indicate that any monetary easing was taking place. The dollar/euro exchange rate bottomed out at about $1.60/euro in March 2008 and fluctuated in a range from about $1.60 to $1.52 until July when it again reached $1.60 and then started rising fast, to about $1.30 when Lehman collapsed. I am curious to see if the rising dollar was mentioned in the FOMC transcripts of the August and September meetings and what, if any significance, was attached to the strengthening of the dollar.
D. Hemphill, You sum it up pretty well.
Benjamin, Thanks. Matthew O’Brien deserves most of the credit. Your concerns are well taken. Janet Yellen has been a strong voice for transparency. Maybe she will have the courage to make some changes, but I am not getting my hopes up.
Tom, Yes, I did. Perhaps I will have something more to say about it. He also wrote a column about it today, in which he seemed to take a slightly harder line on inflation phobia than in Friday’s blog post, but I may be reading too carefully.
I haven’t read the Keynes discussion. If I have time, I will try to catch up. When I looked at it briefly, it looked like something Blue Aurora would be interested in.
Ilya, It’s not the same, but it’s certainly similar. I don’t think that there is a big difference between me and Krugman on inflation phobia, but I don’t think that he quite gets why the Fed could have made a difference if it had eased policy in the summer of 2008.
Tom, My point is that you can’t just look at subprime mortgages in isolation. The economy was contracting rapidly in the summer of 2008. The Fed could have done something about that. If it had, the subprime situation wouldn’t have been as bad and would not have mattered as much.
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David O/T: struggling to understand something about the neutrality of money here. Simple case: Cashless society w/ R reserves (MOA) and D bank deposits (non-MOA). CB takes over the banks. Now there’s 0 reserves and D CB deposits. The quantity of MOA has gone from R to D but prices don’t go from P to P*D/R because demand for bank deposits (non-MOA) was exchanged with demand for CB deposits (MOA). That’s the story I understand from you, Nick Rowe, and I think Sadowski & Sumner too. My question: are bank deposits the only non-MOA good this works with? What if the CB takes over money market funds and replaces them with CB deposits?
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