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On Sept. 18, 2008, Federal Reserve Chairman Ben Bernanke stood before a group of key policymakers and warned: "I am a student of the Great Depression. Let me state clearly: If we do not act in the next few days, this will be worse than the Great Depression."
Ten months earlier, on Dec. 11, 2007, the Fed's Open Market Committee met to discuss the state of the economy. Forget the Great Depression. "Overall," Fed economist David Stockton briefed Bernanke, "our forecast could admittedly be read as still painting a pretty benign picture: Despite all the financial turmoil, the economy avoids recession."
In hindsight, the economy entered recession that very month.
When digging through the just-released transcripts of the Fed's 2007 policy meetings, you can't help concluding that the small group of policymakers who in so many ways hold the keys to the nation's economy was basically clueless.
"Market participants know a lot more now than they did before. Thus, fear is diminishing, which implies less risk of a crisis developing from this source," said William Dudley.
"My forecast for the most likely outcome for output over the next few years is ... growth a little below potential for a few quarters, held down by the housing correction, and the unemployment rate rising a little further," said Vice Chairman Donald Kohn.
During the Fed's July 2007 meeting, the word "recession" was used three times, all referring to past recessions, while the word "strong" was used 61 times, most referring to the then-current state of the economy.
"I think it's fair to say that part of our mistake in 1998 was a failure to appreciate just how strong the U.S. economy was as we entered that period," said David Stockton. "Could we be making that mistake again? Possibly."
It almost takes your breath away.
But as Neil Irwin of The Washington Post wrote:
That's not to say they should have been predicting the gory details of what was to come ...
I did expect, though, that Fed officials would show more evidence of understanding the possibility that the entire financial system had become a house of cards built on mortgage securities that were anything but secure, with all sorts of financial institutions over-levered and overly dependent on assets that were near-impossible to value. And I expected them to understand that once a problem that deep begins correcting itself, it can spiral into all sorts of dangerous directions. Which this one did.
That's really the key here. No one should have expected the Fed to forecast that several Wall Street banks were months away from losing the confidence of overnight lending markets. Or that Barclays would be prevented from taking over Lehman Brothers because of a technicality in U.K. securities laws. Or that the combination of the two would cause a run on the money market industry. Specific events are impossible to predict. But really broad imbalances, like the one we had in credit last decade, don't hide themselves well. Peter Schiff pointed it out. As did Nouriel Roubini, Robert Shiller, Raghuram Rajan, and many others, including yours truly. None got all the details right. But they knew there were imbalances large enough to cause something ugly -- a basic position that most Fed officials were miles away from.
Sure, there were a few dissenters. "The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real," said Fed governor Janet Yellen (who is now vice chairman) in 2007. Treasury Secretary Tim Geithner, who at the time worked at the New York Fed, was more cautious than most and quick to warn that bank conditions were tightening.
But they were the exceptions, and the difference between them and the common view of Fed officials wasn't in the degree of pessimism, but in having any pessimism at all. No one should expect economists to be on the same page, but in hindsight it's shocking how many were reading entirely different books.
Many have wondered why the Fed only releases the minutes of its meetings with a five-year lag. When you compare its past forecasts with what happened in reality, it's easy to see why.