Friday, February 28, 2014

Fed Transcripts 2008

The Federal Reserve recently released transcripts from its meetings in 2008.  Given the significant financial events that occurred in that year, it seems worthwhile to go through the transcripts in some detail. 

As I work through the entire set of transcripts, in addition to a blog post I will post my comments in a new tab, entitled “Federal Reserve Transcripts 2008.”  I will do the same thing for each new post – likely covering one meeting at a time.

First, a quick recap: how did 2007 end at the Fed?  From my post on the released 2007 transcripts:

The Washington Post chimes in:

It was December 2007, and officials at the Federal Reserve were torn between two visions of what was in store for the nation’s economy: a mild slowdown or outright recession.

A staff presentation described a highly unlikely, worst-case scenario that included a 10 percent drop in the stock market.

The New York Daily News:

“I do not expect insolvency or near insolvency among major financial institutions,” Bernanke said at the Fed’s December 2007 meeting, as the economy was already starting to spiral into the Great Recession.

To summarize the Fed’s views at year-end 2007:

·        “a mild slowdown or outright recession,” but no mention of the possibility of the greatest financial calamity to hit the United States and much of the world since the Great Depression;
·        “a highly unlikely, worst-case scenario that included a 10 percent drop in the stock market,” missing the mark by just a wee bit as the S&P 500 fell by more than 50%;
·        Bernanke did “not expect insolvency or near insolvency among major financial institutions,” well Lehman went belly up in the largest bankruptcy in history and the entire lot of them would have followed along had not the Fed and Treasury intervened.

With that, let’s see how 2008 unfolded through the eyes of the official Federal Reserve transcripts.

Conference Call of the Federal Open Market Committee on January 9, 2008

While reading the transcripts, keep in mind the for-public-consumption mandate of the Fed:

The Congress established the statutory objectives for monetary policy--maximum employment, stable prices, and moderate long-term interest rates--in the Federal Reserve Act.  

So how does the Fed start the meeting?  Bernanke opens the floor to Mr. Dudley:

Market function has improved somewhat since the December FOMC meeting. This can be seen most notably in the term funding, foreign-exchange swap, and asset-backed commercial paper markets. In addition, some of the risks of contagion—for example, from troubled SIVs and from financial guarantors to money market mutual funds or the municipal securities market—appear to have lessened slightly.

Nothing referencing the objectives of the mandate.  But I can give the Fed the benefit of the doubt – efficient functioning of markets is buried somewhere in the Fed’s job description; given the risks to the financial system that had to be obvious even to the oblivious, it is at least arguable that Bernanke should start here.

As can be seen on the first page of the handout in exhibits 1, 2, and 3, term funding spreads have fallen sharply for dollar, euro and sterling rates. For example, the one-month LIBOR–OIS spread is now 31 basis points, down from a peak of more than 100 basis points in December.

The use of LIBOR as a measure of financial market health has been exposed as less than valuable – it seems the Fed may have known something about the manipulation of this self-reported rate as early as 2007:

The Federal Reserve Bank of New York may have known as early as August 2007 that the setting of global benchmark interest rates was flawed.

Dudley goes on to report improvements in various financial markets.  All is not rosy, however:

Despite these positive developments in terms of market function, financial conditions have tightened as balance sheet pressures on commercial and investment banks remain intense and as the macroeconomic outlook has deteriorated. This can be seen in a number of respects.

First, large writedowns and larger loan-loss provisions are cutting into bank and thrift capital and pushing down equity prices.

Second, corporate credit spreads and credit default indexes have widened sharply in the past few months, with a significant rise registered since year-end.

Third, equity markets are under pressure. For example, as illustrated in exhibit 11, the S&P 500 index declined in the fourth quarter and, up through yesterday, has fallen about 5 percent so far this year. Moreover, the equity market weakness has broadened out beyond the financial sector. For example, as of yesterday’s close, the Nasdaq index, which has little weight in financials, had fallen 8 percent this year. Global stock market indexes have also generally weakened.

Equity prices are at issue in two of the three comments he makes.

Expectations by the market of possible Fed action are also in focus:

As the economic outlook has deteriorated, market participants’ expectations of monetary policy easing have increased markedly…. Although it is difficult to be precise about this, my best guesstimate is that the market has priced in about a 1-in-4 chance of a 25 basis point intermeeting rate cut. Although that means that a rate cut today would be a big surprise to market participants, it probably would be well understood in hindsight.

At the end of his presentation, Dudley finally gets to inflation (of prices, not money and credit):

Finally, despite the rise in headline consumer price inflation, the uptick in core consumer price inflation, and the atmospherics created by firmer gold and oil prices, market-based measures of inflation expectations remain very well behaved.

Atmospherics?  What does this mean?

Next, Bernanke turns to Dave Stockton (sadly, not Stockman) to speak regarding forecasts:

Our forecast for economic growth in the first quarter is unrevised at an annual rate of ¾ percentage point.

This forecast is made at the beginning of the quarter in question – not for the next quarter, not for the next year; the current quarter.  So, how did he do?

Turning to the labor market, the jump in the unemployment rate in December in combination with our weaker outlook for growth in real GDP going forward has led us to raise our projected level of the unemployment rate to 5.2 percent at the end of 2008 and 5.3 percent at the end of 2009.

This one was just as big a miss: Actual year end 2008: 7.3%; 2009: 9.9%.

As for prices, the recent news on inflation has been disappointing. Total and core PCE prices came in above our expectations in November.

Expectations in November were apparently missed in December.  I would be disappointed also if my ability to forecast was this poor.

Stockton provides a note of caution:

Let me just say a few words about how the risks to the forecast have changed. I believe that the adjustments that we have made to this provisional forecast actually are quite reasonable in light of the developments and the data that we have been contending with, but I’d have to admit that the downside risks to our projection have become more palpable to me.

He goes on to identify housing, labor, and manufacturing as all deteriorating. Yet:

We are not ready to make a recession call yet.

That’s too bad; the recession had already begun by the time Stockton said these words, according to the NBER.

Following a question by Lacker on the sophistication of econometric modeling used by the Fed, Stockton replies:

I believe in nonlinear dynamics. [Laughter] I think I have even experienced them, and probably you have as well on occasion, in terms of the difficulty that we have in forecasting recessions. Our forecast isn’t just some sort of “push a button on a linear model and here is the result.”

Why do they have to invent another term – “nonlinear dynamics”?  Why not just call it what it is – Human Action?  Then they could all just pack up and go home – oh, wait.  That’s why not….

But I do think the current situation illustrates to me why it is, in fact, so hard for us and why we don’t forecast recessions very often.

The Fed is not good at forecasting recessions – go figure.  What is the point of economic central planning via econometric models created by the most sophisticated economists in the world if they cannot forecast a recession?  How can they central plan for something they cannot see?

Bernanke follows with some general comments:

…I think the downside risks to the economy are quite significant and larger than they were. Speaking as a former member of the NBER Business Cycle Dating Committee, I think there are a lot of indications that we may soon be in a recession. I think a garden variety recession is an acceptable risk, but I am also concerned that such a downturn might morph into something more serious…

The “more serious” thing Bernanke is concerned about is the big banks:

Let me talk a bit about banks, which are at the center of this set of issues. I’m going to talk a bit about the 21 large, complex banking organizations (LCBOs).

He goes on to list several measures of bank capital that have demonstrated deterioration, or are forecast to be at risk.

The BIS, at the meeting I attended over the weekend, looking at the 20 largest international banks, estimated $600 billion [of bank capital shortfall]. We don’t know how much it is going to be, but the banks themselves are somewhat unsure about potential exposures.

Since then, the Fed has pumped well over $3 trillion into the system, with most of this held by the banks as excess reserves.  This is far in excess of $600 billion.

Loan-loss reserves are quite low for this stage in the cycle, about 1.4 percent, compared with, say, 2.5 percent during the headwinds period of the early 1990s, and that is partly a result of the SEC regulations, which have forced banks to keep their reserves low.

The changes in accounting rules that took place after the calamity began (mark-to-fantasy) and the multi-year ZIRP both helped to keep loan losses low – another case of bank accounting practices forcing subsequent Fed action.

Finally—and I think this is one of the most worrisome things to me—we are beginning to see some credit issues outside of housing and mortgages. Credit card delinquencies have jumped in a few banks’ home equity lines. There are concerns in commercial real estate, particularly in some regions like Florida and California.

The implications of this, even if the economy continues along, say, the Greenbook’s estimates, are that lending is going to be quite tight.

I have had a lot of opportunities to talk to bankers. We had a meeting over the weekend in Basel between the central bankers and about 50 private-sector representatives. The thrust that I got was that things are going to be pretty tight. “We are going to meet our regular customers’ needs, but all of this is conditioned on no recession.” As one banker put it in our meeting, “There is no Plan B.”

It turns out that there wasn’t even a Plan A.

If the housing market continues to be weak and if credit continues to be tight, then the possibility of a much more significant decline in house prices, particularly in some regions, is certainly there; and that, in turn, would have significant effects on credit markets and on the economy.

The other question I raised was, Have we done enough? We have done 100 basis points. Of course, it is hard to know.

It isn’t “hard to know” if a central planner has done enough or not – it is impossible to know.

…when you have these kinds of risks, the best way to balance the growth and inflation risks is to be aggressive in the short run but to take back the accommodation in a timely way when the economy begins to stabilize.

We must still be in the short run…six years later.

What followed was a discussion around the presentations – each member stated points of agreement and disagreement, and consideration about taking an action in this “intermeeting” meeting.  A few commented on the likelihood of recession in the year 2008.  As to inflation, the statements clearly focused on price inflation as measured by the CPI.  There was little if any concern raised about the consequences of inflation in the money supply. 

Most suggested to not take an intermeeting rate cut.  Yellen was one who disagreed:

I agree with both the concerns that you expressed and the analysis that you offered. Based on the data we now have in hand, I support a 50 basis point reduction in the federal funds rate in the near future. I think a very good case can be made for moving down 25 basis points today, and it would be my preference.

Stern referenced the possibility of blowback, in a manner of speaking:

I think you made an effective case that resilience in this situation could be further inhibited by potentially serious problems in the banking system. I have been concerned for a long time, as you know, that we don’t have incentives right there. While certainly this isn’t proof of anything, I guess we can’t dismiss the possibility that some of the chickens are coming home to roost, and that could affect the outlook as well.

That turned out to be quite a lot of chickens.

Additionally, he sees a “significant policy response” as beneficial to improving the “attitudes” of those on Wall Street:

Also, attitudes, at least in some quarters, seem quite sour today. In particular, the closer people are to Wall Street, the more negative the attitudes appear to be. So all of this suggests to me that the outlook at the moment is not very promising, and a significant policy response on our part is appropriate.

Your attitude would be “quite sour” too if you saw your eight-figure-a-year-for-shuffling-paper annuity stream about to go poof.

Stern ends his comments with an interesting exchange with Bernanke:

Stern: One footnote, since you mentioned it—this is a discussion for another day—as you know, I viewed at the time and I continue to view the 2003 disinflation experience a bit differently than you do, and I think we may want to be careful about the lessons we draw from that experience. Thank you.

Bernanke: If one of the lessons is that we need to take the accommodation back, I agree with you on that one.

Based on Bernanke’s performance throughout the period until his retirement in January 2014, it seems he didn’t learn the lesson.

Plosser, at least in this case living in reality, noted the Fed’s poor track record of taking back accommodation:

…I also share the view of President Lacker that, although we may want to take accommodation back quickly, the history of this institution is that it doesn’t do that very well.

Hoening shared this concern:

My concern—as others have expressed, but it is a very serious concern on my part—is that we say we can reverse the policy position or raise interest rates later.

This was such a serious concern that it has been ignored for six years…and counting.

Kohn wanted to make clear he was “not going to get pushed around by the market”:

If you look at the market—and, President Fisher, I assure you I am not going to get pushed around by the market—I do think the market is telling you that there are a lot of people out there who think that the funds rate has to drop 100-plus basis points more, and they don’t think that will be consistent with a pick up in inflation.

He then followed this bold stand against Wall Street by saying he would support an immediate rate cut based on recent performance in the market:

In sum, I agree that we need to reduce rates substantially just to get close to buying insurance.  I would do it sooner rather than later.  I would have been prepared to support an intermeeting move today.  I think the data are weak enough; we are far enough behind the curve.  To me, looking at the equity market declines, what we have seen since the middle of December is a bit of a loss in confidence in the financial markets that we will do enough soon enough to keep the economy on an even keel.

Ah, the pesky prop-up-the-equity-market mandate.  Wait, did I miss something?

Warsh echoed Bernanke’s concerns about the large financial institutions:

The problems among large financial institutions are very serious, and unlike financial market functioning, which has improved, I think the state of these institutions has not improved since we met last.  While it is true that they have been raising capital, both in the form of equity and convertibles, the process of writedowns and capital-raising is far, far from being complete.

The inability of the banks to act as “shock absorbers,” given the condition of the bank balance sheets, as well as the lack of stimulative fiscal policy, has Warsh feeling lonely:

If you think about that in terms of other shock absorbers that might be available, including fiscal policy, I think there is reason for the seventeen of us on this conference call to feel relatively lonely in thinking about policies that can be brought to bear, both from the private sector and the public sector.

The lonely feeling can be easily avoided – leave decisions about money and credit to the market.  Hundreds of millions of people will then keep you company.

Kroszner notes the off-balance sheet tools that the large banks have used to increase credit over the preceding several years:

Basically, over the last five years or so, the reason that financial institutions could provide so much intermediation and so much support is that things didn’t stay on the balance sheets.  Now, because there is an impaired ability to get things off the balance sheets, it requires much more capital to support the same amount of funding that had occurred in the past.  Just to try to keep funding at the same old levels is going to require dramatically more capital.

So not only were banks overleveraged – they levered-up their overleverage via off-balance sheet entities.

He further touches on inflation – it’s all in the expectations:

With respect to inflation, as a number of people have mentioned, there are some disturbing readings recently.  But something that is heartening, and for me is really the most important thing, is that I don’t see much evidence so far of a significant change in expectations, because that is really where the long-term costs of our policy moves come in.

Mishkin also focused on the expectation of inflation:

One concern that people have raised is the potential upside risks to inflation.  I am less worried about that than some other members of the FOMC for the following reasons.  Very importantly, inflation expectations seem very solidly grounded.  We have had no indication of any deterioration in terms of inflation expectations, despite our previous easing moves and the very high increases in energy prices. 

As long as people don’t expect inflation, apparently there won’t be inflation.

Second, when I think about what drives inflation and what are the dynamics of the inflation process, what is important are expectations not only with respect to inflation but also with respect to the future path of output gaps. 

It’s also apparently about idle capacity.

In particular, I do not see at this juncture that people are worried that we are going to allow the economy to get overheated. 

Perhaps this is why the Fed has allowed the economy to remain under-heated in the six years since this meeting?  The arrogance of Mishkin’s statement – as if the Fed has god-like power: “we are going to allow the economy.”  Allow?

In fact, it is the opposite right now.  We are more worried about the downside risks, where there will be increased economic slack in the economy, and of course, that is consistent with the forecast coming from the Board staff.  So when I think about the inflation process, I think in terms of underlying inflation, which is inflation not over the next year but over the longer run, which is appropriate for monetary policy and when we can have an effect.  I do not see that the upside risk is huge there; in fact, this is very important in terms of allowing us to be aggressive in this situation of financial disruption.

At least as price inflation is commonly measured, he has been right so far – and may continue to be right for some time to come. 

Geithner, Vice-Chairman at the time, wants to go in guns-a-blazin’:

I think there is more risk to us now in gradualism than in force.

They always like to use force.

His comments were otherwise the squishiest of all – like he didn’t want words of any substance on the record.

Bernanke thought to keep news of this intermeeting meeting secret – news of it would not come out until three weeks after the regularly scheduled meeting to be held three weeks hence:

It will be described, I assume, in the minutes, which will be three weeks after the next meeting, so it will be six weeks before this is reported.  It will be reported, I assume, as a consultation and discussion of the economy.  I would advise you not to discuss this with your directors.  If it gets into the market, it could cause confusion and uncertainty.  So if possible, I would not discuss it.

This ends the first meeting of 2008 – a telephonic intermeeting.  No action was taken on rates.

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