How the Fed Let the World Blow Up in 2008


The Fed transcripts have been released. What was going on inside the Fed was actually worse than we thought. No, they didn’t have a time machine to see exactly how bad it would be, but some members had read their history and argued for action. Sigh. And it gets worse, as the Fed continues the tight money policy into 2009. Matt O’Brien writes: 

…But the Fed was blinded. It had been all summer. That’s when high oil prices started distracting it from the slow-burning financial crisis. They kept distracting it in September, even though oil had fallen far below its July highs. And they’re the reason that the Fed decided to do nothing on September 16th. It kept interest rates at 2 percent, and said that “the downside risks to growth and the upside risks to inflation are both significant concerns.”

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.” 

Note the discussion re Milton (and Scott Sumner), that you can’t judge easy money by short term rates. Here’s Scott Sumner on Matt O’Brien on the Fed’s mistakes during 2008 

…A few comments:

1. The flawed monetary regime (failure to level target NGDP) made these seemingly small tactical errors in mid-2008 much worse than they would otherwise have been.

2. I am pretty sure Matt is not a market monetarist, or at least he’s more Keynesian on issues like fiscal stimulus than I am. Thus it’s heartening to see the MM interpretation of 2008 become increasingly accepted by the mainstream press. When people like David Beckworth and I were starting out on this crusade, the notion that excessively tight money was the problem was almost laughed off the stage. ”Interest rates were 2%, how can you claim money was tight in 2008?” Now the MM narrative is becoming increasingly accepted in the media. That’s great news.

3. Elsewhere Matt praises Frederic Mishkin. He also directed me to a Hilsenrath piece that said Mishkin came off looking relatively bad in the transcripts. But Hilsenrath was focusing on Mishkin’s jocular style. If you look at content of his analysis he was ahead of most of his colleagues. (In terms of forecasting Rosengren seems to have been the best.) I did a post over at Econlog a few days ago praising Mishkin’s farewell comments, but forgot that he had been equally brilliant at the final meeting of 2007.

More from Scott Sumner here:

The market monetarist view that tight money caused the recession is getting some play in the press. Here’s an excellent piece by Ramesh Ponnuru:

There’s another view of the Fed’s role in the crisis, though, that has been voiced by economists such as Scott Sumner of Bentley University, David Beckworth of Western Kentucky University and Robert Hetzel of the Richmond Fed. They dissent from the prevailing view that the Fed has been extremely loose since the crisis hit. Instead, they argue that the Fed has actually been extremely tight, and that when its performance during the crisis is measured against the proper yardstick, the central bank emerges as the chief villain of the story.

In the second half of 2008, housing prices, many commodity prices, inflation expectations and stocks all suggested deflation was coming. Fed officials, though, kept talking about backward-looking measures of inflation that made it look high. Their hawkish pronouncements effectively tightened monetary policy by shaping market expectations about its future direction. In August 2008, the Fed minutes explicitly said to expect tighter money. Even after Lehman Brothers Holdings Inc. collapsed the following month, the Fed refused to cut rates and fretted about inflation (which didn’t arrive). A few weeks later, the Fed decided to pay banks interest on excess reserves, a contractionary move. Only then did it cut interest rates.

Chuck Norris beats Wolfgang Schäuble

Here's excerpts from a recent post by market monetarist Lars Christensen:

So far it is has been a remarkable week in the global financial markets. The ’deposit grab’ in Cyprus undoubtedly has shocked international investors and confidence in the ability of euro zone policy makers has dropped to an all-time low.

Despite of the ‘Cyprus shock’ global stock markets continue to climb higher – yes, yes we have seen a little more volatility, but the overall picture is that of a continued global stock market rally. That is surely remarkable when one takes into account the scale of the policy blunder committed by the EU in Cyprus and the likely long-lasting damage done to the confidence in EU policy makers.

I therefore think it is fair to conclude that so far Chuck Norris has beaten German Finance Minister Wolfgang Schäuble. Or said, in another way the Chuck Norris effect has been at work all week and that has clearly been a key reason why we have not (yet?) seen global-wide or even European-wide contagion from the disaster in Cyprus.

Just to remind my readers – the Chuck Norris effect of course is the effect that monetary policy not only works through expanding the money base, but also through guiding expectations.

When I early this week expressed my worries (or rather mostly my anger) over the EU’s handling of the situation in Cyprus a fixed income trader who is a colleague of mine comforted me by saying “Lars, you have now for half a year been saying that the Fed and the Bank of Japan are more or less doing the right thing so shouldn’t we expect the Fed and BoJ to offset any shock from the euro zone?” (I am paraphrasing a little – after all we were talking on a trading floor)

The message from the trader was clear. Yes, the EU is making a mess of things, but with the Bernanke-Evans rule in place and the Bank of Japan’s newfound commitment to a 2% inflation target we should expect that any shock from the euro zone to the US and Japanese economies would be ‘offset’ by the Fed and the BoJ by stepping up quantitative easing.

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