Federal Reserve Underestimated Crisis In 2007, Before Sounding Alarm

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The Federal Reserve published the transcripts of its closed-door policy meetings in 2007 before the financial crisis officially began. It was a year that pulled the U.S. economy into the deepest recession of modern times. The transcripts are released with a five-year time lag, and provide a clear view that the central bank initially underestimated the threat of a looming crisis.

Federal Reserve Underestimated Crisis In 2007, Before Sounding Alarm

The transcripts of three emergency videoconference calls and eight meetings of the Federal Open Market Committee, show how the policymakers tried to grapple with the rapidly spreading crisis. The first policy change came during an emergency videoconference on Aug. 16, when the Fed decided to cut the discount rate. Later, short-term interest rates were cut in September, October and December.

In the beginning of 2007, the Fed had put interest rate policies on hold, and most of the policymakers were comfortable about the economic outlook. Even in December 2007 when the recession officially began, officials were working based on economic projections that were 100% inaccurate. They predicted slow but sustained growth in 2008 and an impressive bounceback in 2009. Even as the crisis began in December, they believed that problems with the subprime mortgage market will be contained.

Whenever the debates raged during the meetings, Fed chief, Ben Bernanke, often took the middle ground. For example, he was considering a hefty, half-percentage point reduction in the benchmark interest rate to contain the economic blow. But he chose a middle point – a quarter percentage point reduction. Many times, even his projections proved wrong. For example, he predicted in January that the worst outcomes of housing were almost negligible. In May, he said that he could see strong fundamental reasons to believe that U.S. economic growth will be moderate.

It was during the latter half of 2007 that Bernanke began to realize that the financial strains were going to move beyond the housing markets to the broader economy. In September, he became concerned about something that would eventually become a reality. He thought that the Fed’s interventions to rescue the financial institutions will be perceived as bailout of individual banks, instead of as attempts to stabilize the broader economy.

“As the central bank we have a responsibility to help markets function normally and to promote economic stability, broadly speaking. We are not in the business of bailing out individuals or businesses.” A few months later, that the central bank bailed out the American International Group, Inc. (NYSE:AIG) and Bear Stearns.

Timothy Geithner, then president of the New York Fed and current Treasury Secretary, downplayed the troubles at two hedge funds controlled by Bear Stearns, which was eventually a turning point in the crisis. The only person to have sensed the growing risk to the economy was Janet Yellen, the then president of San Francisco Fed and now vice chairman of Federal Reserve.

“I still feel the presence of a 600-pound gorilla in the room, and that is the housing sector. The risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst,” Yellen said in June 2007. By December 2007, she began to push the Federal Reserve for aggressive measures to control the turmoil. She was in favor of half-percentage point reduction in interest rates to cushion the blow.

Janet Yellen is the most likely candidate to succeed Ben Bernanke when he leaves the Federal Reserve in January 2014.

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