As we approach the 10th anniversary of the Great Recession, a new analysis of the evidence suggests that, before the September 2008 collapse of Lehman Brothers, the Federal Reserve’s policy decisions, likely motivated by an exaggerated and misplaced fear of inflation, deepened the recession, thereby intensifying the stresses disrupting a weakened financial system.

This is David Glasner’s argument in “The Fisher Effect and the Financial Crisis of 2008.” While the Fed was laser-focused on inflation, the real danger was recession and financial instability.

With real (inflation-adjusted) short-term interest rates close to zero, the Fed was trying to restrict credit to keep inflation expectations from rising. Unable to borrow, and facing a precarious financial environment and a deteriorating real economy, cash-strapped firms, merchants, and traders began liquidating their positions, triggering a cascading collapse of asset prices.

At this critical moment, falling inflation expectations reinforced the downward pressure on asset prices and output and employment. Yet the Fed, still fixated on an imagined threat of inflation, delayed reducing nominal interest rates, further exacerbating the crisis.

When Inflation Can Be a Good Thing

Inflation, with good reason, is generally regarded as undesirable. But when real interest rates are close to zero, deflation or expected deflation can be even worse. Deflation causes people to hoard money, and an increased demand to hold cash reinforces a downward spiral of falling asset prices and shrinking output and employment.

In such dire circumstances, monetary expansion intended to raise prices and temporarily increase inflation can actually help prevent a recession and start a recovery. The real failure of the Fed was to maintain the anti-inflationary policy, which caused a downturn late in 2007, long after it became necessary to shift to an expansionary policy.

Key Takeaways