Meeting of the Minds
As late as September 2008, the FOMC’s primary concern remained inflation. There were caveats and characterizations abounding through the conversation, but each time they kept coming back to uncomfortably high inflation and the extrapolations of that through their models. The old Philips Curve dies hard, and even with the financial turmoil already rotting through the entire edifice, policy discussion was primarily about inflation.
That suggests, and strongly so in no uncertain terms, that the entire economic philosophy “guiding” policy is corrupted by, again, ideology. What they had before them was what they considered conflicting data points – consumer inflation that remained high, mostly in the form of commodity prices, at the same time economic activity was coming in far softer than they had ever expected, even just months earlier.
My sense of this confusion is that it led to this recency bias that infected the entire discussion, and thus policy regime; not only for that meeting but throughout the entire crisis period. There were no surprises after Lehman failed, indeed after Bear Stearns. They knew they were in a crisis, and more striking, they knew markets were growing seriously stressed.
BILL DUDLEY, “Probabilities placed on either easing or tightening were quite low, and since then the probability of easing has gone up fairly significantly. But I think it’s hard to interpret because it’s really not about 25 versus zero. It’s really about zero versus 50 or maybe even 100 as you look out longer term. Either the financial system is going to implode in a major way, which will lead to a significant further easing, or it is not.” [emphasis added]
Time and again, they kept coming back to this “bimodal” probability distribution.
CHARLES EVANS, “Today, the downside risks to output are almost too dispersed to characterize. In one or two weeks, we may know better that either the economy will somehow muddle through or we’re likely to be facing the mother of all credit crunches. I think that the first outcome would be quite an accomplishment under the circumstances, but at the moment it’s very hard to say how this will turn out.” [emphasis added]
Either it was going to be really bad, or the economy and markets would come out fine. And every time their inclination was to trust their models (where inflation was the primary problem) that somehow it would all work out for the best, rather than what they saw and felt. That was reinforced not only in the US but internationally.
DONALD KOHN, “There has been a lot of concern not only in the United States but in other countries as well, as I heard in Basel last weekend, about a spillover—that the problems were not confined to the mortgage markets but were spilling into the loan books of the banks. That was related to the weakening in economic activity and was tightening up credit conditions, which would, in turn, further weaken economic activity. So this feedback loop was at work certainly in the United States and was beginning to be felt a little more in other countries as well.”
They had all the pieces in their hands, yet again, but it was continually dismissed as the ultimate effects were mystically unclear.
CHARLES PLOSSER, “The economy remains weak but not appreciably different from what I anticipated or even what the Greenbook anticipated at the last meeting. I agree that the recent financial turmoil may ultimately affect the outlook in a significant way, but that is far from obvious at this point.”
Far from obvious? Remember, this was a day after Lehman Brothers had failed, and three other major concerns, including AIG (which drew much of the discussion), teetered on the edge. They had economic accounts that unrelentingly undercut each and every forecast, coupled with those failures abundant in the financial sector, but the ultimate dispositions were “far from obvious?” Later, President Plosser reiterated that stance,
MR. PLOSSER, “A cut today may be reassuring to some in the financial markets, but it also may serve to scare markets by sending a signal that we are much more worried than perhaps they are. There is just way too much volatility and dust blowing around to make such snap judgments on monetary policy. We have been aggressive with our liquidity provisions, and we will continue to be so, and I support that. Stability coming from monetary policy is an important attribute, and I think we have an opportunity to provide some stability here. However, I am uncomfortable with the current Greenbook baseline path that has the funds rate remaining unchanged well into the second half of next year. In my view, that will not deliver an acceptable path of inflation outcome over the medium term.” [emphasis added]
But markets, removed from being true discounting mechanisms, were making “snap judgments.” And the FOMC kept referring to it directly, including the exact path “contagion” would ultimately take to panic:
MR. WARSH, “I think the question before us today that’s hard to judge is whether financial markets are now to the point at which they are acting indiscriminately, testing all financial institutions regardless of capital structure or business model. I’d say that the evidence of the past twenty-four or forty-eight hours is still unclear.”
Governor Warsh was eerily succinct in his summation of it:
MR. WARSH, “Look at the CDS spreads for the two remaining independent broker-dealers, Goldman Sachs and Morgan Stanley, which Bill referenced. Goldman Sachs’s CDS moved up another 190 or so morning. They are up 340 in the last two days. Morgan Stanley’s are up 690. I wouldn’t want to say whether those numbers are right or wrong. It may be that the business model is a failing one—that is, wholesale funding is no longer practicable in the world that we’re now in. If the problems were confined to that part of the financial services industry, it would be tough and it would be ugly and, if you were a resident of New York, particularly painful. But I don’t think it would rise to the level that would force us to recalibrate monetary policy.” [emphasis added]
He had the answer right there, “wholesale funding is no longer practicable”, but then that recency bias crept back in at the end and the scary scenario was buried in circling the wagons against even raising questions about the monetary paradigm. In perhaps a preview of the next five-plus years, markets were simply not to be trusted.
As if to put an exclamation point on this disconnect between what was taking place in the financial system and the implications for the real economy, the idea of a muddle economy was born as a subsistence alternative to a far worse fate. It was just too easy and comfortable to fall back on the models, ferbus, the Greenbook, et al, despite all these expressed reservations that they collectively felt on some level it was likely to be worse than all that.
DONALD KOHN, “Not all news affecting spending has been negative. Capital goods orders have held up. The decline in interest rates and commodity prices that respond to the markdown in global growth will help support domestic demand, and actions to stabilize the GSEs are helping the mortgage market. Activity is more likely to stagnate than to decline.”
Rationalizations are not reserved solely for bubble investors. They apply equally to political agencies themselves confined within one.
I have often couched modern FOMC actions in a slightly Marxist paradigm; it is, after all, a system of centralized control over economic and monetary affairs. But until reading the transcripts here I realize that it should not be limited to one Marx. Groucho Marx once asked, “Who are going to believe, me or your lying eyes?” That sums up the FOMC actions in 2008, unfairly comfortable distrusting their own sight – when Karl Marx met Groucho Marx.
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