The 2008 transcripts: The real issues By Scott Sumner

The Fed releases the detailed minutes of its meetings with a 5 year lag. Bloggers that follow monetary policy closely have been eagerly awaiting the 2008 minutes, expecting all sorts of revealing (and perhaps embarrassing) quotes. Although I haven’t yet had time to read the minutes, the excerpts that I have read were about what I would have expected. We already knew what the Fed did wrong, and what they were thinking when they made their mistakes. I’m sure the minutes will add to that knowledge, but I doubt they will alter the general picture.

Dovish critics of the Fed have pounced on many of the embarrassing statements, which look especially appalling in retrospect. More sympathetic observers talk about the benefits of hindsight, significant data lags, etc. Both have good arguments, but both are overlooking an important point.

The Fed does roughly what a consensus of elite academic economists think they should be doing. I don’t recall any significant outrage in the academic community, or even among policy pundits in the press and blogosphere, as the Fed made its crucial mistakes in 2008. Matt Yglesias calls Boston Fed President Eric Rosengren a “hero” for his dissent in September 2008. I have no problem with that characterization, but of course that’s exactly the problem, isn’t it? No massive bureaucratic machine that depends on well-timed “heroics” will ever be reliable. (This is one area where I won’t have to try very hard to convince my Austrian critics!)

The real problem with policy in 2008 was not that the Fed wasn’t able to forecast the oncoming disaster; I didn’t foresee the severity of the recession until the data began to show the crash of late 2008. Rather the real problem was that policy was far too contractionary even given the real time market data that the Fed had available. This can be illustrated with a “tale of two meetings.”

To be fair to the Fed, the unfolding economic collapse took a lot of people by surprise. And the Fed did act fairly aggressively when it got around to acting. But these records are reminders that the human beings pulling the strings of the world’s largest economy are no better than most other economists at predicting the future. “We were seriously behind the curve in terms of economic growth and the financial situation,” then-Fed Chairman Ben Bernanke said during an emergency conference call on Jan. 21, 2008. It would not be the last time. The Fed decided on that call to slash its key interest rate by three-quarters of a percentage point, a shockingly bold move after it had decided not to cut rates during another emergency call just 12 days earlier. Even with the large cut on Jan. 21, the Fed knew it hadn’t done enough. Bernanke suggested that it should have cut by a full percentage point or more. Instead, it waited just nine days and slashed another half-percentage point from its target rate on Jan. 30.

In its December 2007 meeting, the Fed discussed whether to cut rates by 1/4% or 1/2%. They opted for 1/4%. Stocks immediately crashed on the news, indeed fed funds futures probabilities, combined with the more that 2% plunge in the market, suggest the decision depressed stock prices by about 5%. Adding in global markets and you are talking about trillions of dollars. All that wealth riding on one quarter point. That’s what Bernanke meant by “behind the curve.” Market monetarists would say he was “behind the market.”

But I’m going to count Bernanke’s January make up call as a limited policy success, despite the fact that the recession began in December 2007. With the soaring global oil prices it would have been difficult to prevent a mild recession in 2008. The Fed’s vigorous moves in January kept output flat in the first half of 2008. Now let’s look at how the Fed reacted to a similar challenge in September 2008, right after Lehman failed. At the meeting of September 16, 2008, the Fed made one of its most revealing errors:

At that time, many Fed officials were far more worried about inflation risks than about the risk of an economic collapse and depression. The word “inflation” occurs 129 times in the Sept. 16 transcript; the word “recession” was uttered just five times. (“Laughter” is noted in the transcript 22 times.) Even current Fed Chair Janet Yellen — who was then the president of the San Francisco Fed and had frequently been prescient about the growing risks to the economy — argued for standing pat on Sept. 16. She did so despite the fact that she still saw signs of growing economic weakness, including a slowdown in demand for plastic surgery in wealthy San Francisco neighborhoods. Financial markets kept deteriorating in the days after that meeting, prompting an emergency Fed conference call on Sept. 29. Amazingly, the Fed again decided to take no action. It wasn’t until Oct. 7 that the Fed finally got around to cutting interest rates. Even then, some Fed policy makers wanted to quibble about the Fed’s outlook for inflation, refusing to believe that the economy had tipped into a deep hole.

The Yellen vote is a clue to the fact that the real problem in 2008 was not an excess of inflation hawks like Fisher and Plosser, nor a lack of “heroes.” The real problem was that the Fed was working with a highly flawed New Keynesian policy approach, loosely related to the Taylor rule (albeit not exactly.)

This is why replacing the FOMC with 12 other “highly qualified” economists in 2008 would not have helped. The only way to have prevented a severe recession in 2008 would have been to have 12 supporters of market monetarism, or at least 12 supporters of NGDP level targeting. Back then the two groups would have had a lot of overlap, but since then many elite NKs have endorsed NGDPLT, including Michael Woodford, Jeffrey Frankel, Christina Romer, etc. The profession is moving in the right direction, and I suspect that even Ben Bernanke would do better the second time around.

How do I know that market monetarists would have gotten it right? Note that on the very day of the September 16 meeting, the meeting at which the Fed refused to cut rates due to fear of “high inflation,” the TIPS spreads were showing only 1.23% inflation over the next 5 years, well below target. The Fed should have ignored its own worries about inflation, and instead relied on the wisdom of the crowds. The crowd is not always right, but they are more reliable than the Fed, especially when conditions are changing rapidly. Market participants saw the bottom dropping out of the economy using millions of pieces of highly dispersed information, while the clumsy Fed waited for macro data that comes in with long lags. Hayek would understand.

An even better approach would be to set up a NGDP futures market, and use it to guide a level targeting policy of NGDP growth, perhaps at 4% to 5% per year. As long as NGDP growth expectations are fairly stable, it is unlikely that we would have anything more than a very mild recession. Stable NGDP expectations would have also helped to make asset prices less volatile, and recall that the failure of Lehman was partly due to plunging asset prices. On the other hand our financial system is still riddled with moral hazard, so NGDP targeting is not a cure-all. But if we know that NGDP growth expectations would be stabilized, then it would be easier to say no to bailouts.

BTW, all the points in this post were made in earlier posts over at TheMoneyIllusion, well before the transcripts were released. Market monetarists saw the mistakes occurring in real time; I’d guess that other pundits now bashing the Fed for 2008 were mostly silent as the mistakes were actually occurring.

PS. I do know that the recession was already getting severe by September 16, 2008. That’s where level targeting comes in. Had the policy been NGDPLT at 5% growth, then market expectations would have been much more bullish in the summer of 2008 and output would have fallen much less in the third quarter. Thus market monetarist policy proposals could have helped the economy even before the fateful September meeting. I worry that readers will get the wrong message from this post—it’s wasn’t one fateful decision in September, it was a flawed monetary regime that caused the recession.

PS. Marcus Nunes has a very good post, focusing on policy mistakes made in mid-2008. In the comment section of this post you will find more excellent comments by people like Mark Sadowski and Steve.