The day after Lehman Brothers went bankrupt, touching off a financial panic that would bring the insurance giant AIG to the brink of disaster and the world economy to its knees, the Federal Reserve's Federal Open Markets Committee had its regularly scheduled policy meeting. The Fed, which had that weekend determined with the Treasury Department that it didn't have the legal tools to save Lehman although it helped JPMorgan rescue Bear Stearns in March of that year, was not united in its view of where the economy was going.
Transcripts from that meeting, which were released along with all other meeting transcripts from 2008, show a few Fed governors, staffers, and regional presidents persistently concerned with the economy as its careened into the worst recession since the Great Depression but several others, especially some of the regional presidents, more concerned about inflation and skeptical about the necessity of the Fed's far-reaching interventions to keep the financial system afloat.
One particularly stark contrast is seen between the president of the Boston Federal Reserve Bank, Eric Rosengren, and the president of the Dallas regional Fed, Richard Fisher.
"This is already a historic week, and the week has just begun. The labor market is weak and getting weaker," Rosengren said, "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. Individuals and firms will become risk averse, with reluctance to consume or to invest...The degree of financial distress has risen markedly."
Since the crisis, Rosengren has become one of the most persistent voices for more aggressive Federal Reserve action to aid the economy.
These words proved prescient and Rosengren marked out a noticeably more dovish stance on short-term interest rates, saying he supported a .25% cut, which the FOMC decides on, than even Janet Yellen, then the head of the San Francisco Fed, and who had been worried about economic distress since early that year. The Fed would decide to keep the federal funds rate at 2%. They brought rates down to 1% by the end of October and .25% in December.
Richard Fisher, a conservative former money manager who lead the Dallas Fed, had markedly different concerns. Fisher throughout the year expresses frequent concerns about rising inflation, but in the September meeting says it has mitigated (although he notes that his favorite bagel joint had recently raised its prices).
Fisher cautioned the Fed not to do too much too quickly. He said that the Fed must make sure "not to lose control, to show a steady hand." He also said that he didn't want the Fed's statement of policy that it would issue after the meeting to make it seem like "we are focusing only on markets." Although Fisher supported the crisis-era interventions, he has since become a frequent critic of the Fed's efforts to spur economic growth, calling the Fed's massive bond buying program, "monetary morphine."
Thomas Hoenig, who headed up the Kansas City Fed and is now at the Federal Deposit Insurance Corporation, is a critic of the industry and a persistent advocate for stronger financial regulation. He said in September that the Fed should "look beyond the immediate crisis" and talk about the the inflation issue. "Our core inflation is still above where it should be," he said.
Inflation would fall off during the economic crisis and would fall to a 53-year low.
Fed Governor Kevin Warsh, who was appointed by President Bush, took a more granular look at what was going on in the financial markets and spotted possible trouble. Warsh, who had worked at Morgan Stanley and on financial policy in the Bush White House, said that "if an AAA company like AIG were really fundamentally insolvent, the direct losses to a range of institutions, particularly those that are not just wholesale institutions but are retail institutions, could be very significant." This is more or less precisely what happened: AIG was rescued by the federal government, starting with $85 billion the day after Lehman's bankruptcy that would eventually add up to a $180 billion total commitment.
Elizabeth Duke, another Fed Governor appointed by President Bush, was an executive at several regional and community banks and her testimony portrays a deep knowledge of how banking and credit was being disrupted by financial stress, "The markets are fragile to dead," she told the FOMC, "So what are they going to do? The only thing they can do is contract the balance sheet and not lend."
This is precisely what happened: Credit across the economy shriveled up and helped accelerate the economic crisis. "Any heavy uses of credit or predominant uses of credit are just not being done," Duke concluded. She also pointed to regional dynamics in the housing markets, noting colorfully that "Florida is a bottomless hole—speculation combined with insurance problems. In Arizona so much land was available that they can't find a bottom there."
Janet Yellen, who was then head of the San Francisco Fed and is now the Fed's chair, said that "We are fighting an uphill battle against falling home prices, an economy in recession and collapsing confidence...Given the seriousness of the situation, I believe that we should put as much stimulus into the system as we can as soon as we can." Yellen has been perhaps Bernanke's strongest ally in supporting a wide range of Federal Reserve tools to lower unemployment and encourage economic growth.
After that September meeting, much of the financial structure that had been teetering over the summer crashed down immediately, straining the Fed and Treasury's resources to arrest the broadest banking panic since the Great Depression: the Treasury backstopped the entire money market industry to stave off a run, Washington Mutual was seized by regulators and sold off to JPMorgan, Wachovia was snapped up by Wells Fargo, Merrill Lynch was bought by Bank of America, and Goldman Sachs and Morgan Stanley both courted multi-billion investment to shore up their financials and were converted overnight into "bank-holding companies" in order to receive Federal Reserve aid.
And the real economy plummted too, bearing out Rosengren's concerns about the financial system's problems infecting everyon else.
In the Fed's next meeting in October, Bernanke said that "financial conditions appear already to have had a significant and remarkably quick effect on activity and consumer and business expectations and plans." He was more right than he even knew: subsequestion revisions to macroeconomic data shows that the economy was in much worse shape than the Fed — or anyone else — knew at the time.
But even before the economy shuddered in September — the economy contracted more than 8 percent in September according to current figures — some of the more dovish Fed officials had been long worried. Yellen in January 2008 said that "the risk of a severe recession and credit crisis is unacceptably high, and it is being clearly priced now into not only domestic but also global markets." According to the National Bureau of Economic Research, the recession had only started a month prior and would last until June.
By December, at a specially planned meeting to address the rapid detioration of the econmy, Bernanke said, "The financial and economic crisis is severe despite extraordinary efforts not only by the Federal Reserve but also by other policymakers here and around the world." By then, everyone in the room would agree. But only because events had gone the way a few had predicted. And others hadn't.