On the morning after Lehman Brothers filed for bankruptcy in 2008, most Federal Reserve officials still believed that the American economy would keep growing despite the metastasizing financial crisis.
The Fed’s policy-making committee voted unanimously against bolstering the economy by cutting interest rates, and several officials praised what they described as the decision to let Lehman fail, saying it would help to restore a sense of accountability on Wall Street.
James Bullard, president of the Federal Reserve Bank of St. Louis, urged his colleagues “to wait for some time to assess the impact of the Lehman bankruptcy filing, if any, on the national economy,” according to transcripts of the Fed’s 2008 meetings that it published on Friday.
The hundreds of pages of transcripts, based on recordings made at the time, reveal the ignorance of Fed officials about economic conditions during the climactic months of the financial crisis. Officials repeatedly fretted about overstimulating the economy, only to realize time and again that they needed to redouble efforts to contain the crisis.
The Fed’s chairman at the time, Ben S. Bernanke, was unusually clearsighted in warning of the risk of a severe recession as the nation entered into a presidential election year. But he struggled to persuade his colleagues, and at crucial junctures he did not push forcefully for stronger action.
The Fed’s current chairwoman, Janet L. Yellen, then the president of the Federal Reserve Bank of San Francisco, was even more alarmed by the deterioration of economic conditions. She and Eric Rosengren, president of the Federal Reserve Bank of Boston, are the most forceful and persistent advocates for stronger action in the transcripts. But they, too, underestimated the downturn until the final months of 2008.
The transcripts also show, however, that Fed officials responded decisively in those final months, probably preventing an even deeper recession. By the end of 2008, the Fed had reduced short-term interest rates nearly to zero for the first time since the Great Depression, and it had become a primary source of funding not just for the global financial system but for American homeowners and for companies that made food and cars.
Ms. Yellen summed up this new ethos at a Fed meeting six weeks after Lehman’s failure, telling colleagues, “Given the seriousness of the situation, I believe that we should put as much stimulus into the system as we can as soon as we can.”
In normal times, the Fed is a powerful but somnolent institution, charged with keeping a steady hand on the rudder of the economy. It moves interest rates up and down to moderate inflation and minimize unemployment. But beginning in 2007, it was forced to take on a far more challenging role as the central backstop for the global financial system.
The Fed’s understanding of the crisis, however, was clouded by its reliance on indicators that tend to miss sharp changes in conditions. The government initially estimated, for example, that the economy expanded in the first half of 2008 because it basically assumed that some economic trends, like the pace of business creation, had continued apace. The Fed also relied on economic models that assumed the existence of smoothly functioning financial markets, limiting its ability to project the consequences of a breakdown. And the outlook of Fed officials also reflected a deeply ingrained bias to worry more about the risk of inflation than the reality of rising unemployment.
As Fed officials gathered on Sept. 16 at their marble headquarters in Washington for a previously scheduled meeting, stock markets were in free fall. Housing prices had been collapsing for two years, and unemployment was climbing.
Yet most officials did not see clear evidence of a broad crisis. They expected the economy to grow slowly in 2008 and then more quickly in 2009.
The transcript for that meeting contains 129 mentions of “inflation” and five of “recession.”
Mr. Bernanke even told his colleagues that it was clear the economy had entered a downturn but that he still did not favor cutting rates.
“I think that our policy is looking actually pretty good,” he said.
That optimism would not long endure. Just minutes after the end of that first meeting, a smaller group of Fed officials agreed to rescue the faltering insurance giant the American International Group, a company never before subject to Fed supervision that until then was barely on the government’s radar.
In the succeeding weeks, as evidence of a downturn became unmistakable, the Fed would announce a seemingly endless series of programs to buttress the economy, leading Fed officials to joke about the resulting alphabet soup of acronyms.
In early October, a few weeks after the decision to stand pat, the Fed convened an unscheduled meeting to cut interest rates in an action coordinated with other major central banks.
“It’s more than obvious that we have an extraordinary situation,” Mr. Bernanke told colleagues.
“I should say that this comes as a surprise to me,” he said. “I very much expected that we could stay at 2 percent for a long time, and then when the economy began to recover, we could begin to normalize interest rates. But clearly things have gone off in a direction that is quite worrisome.”
He closed on a prescient note, telling the committee that he did not expect that monetary policy could solve the problem, but that the Fed should not be hesitant to use the tools that it had.
By the end of the year, the Fed had cut interest rates nearly to zero and started to buy mortgage bonds in a further effort to stimulate the housing market and the broader economy. More than five years later, it is still pursuing both policies even as the economic recovery remains incomplete.
Some Fed officials have argued that the Fed was blind in 2008 because it relied, like everyone else, on a standard set of economic indicators.
As late as August 2008, “there were no clear signs that many financial firms were about to fail catastrophically,” Mr. Bullard said in a November presentation in Arkansas that the St. Louis Fed recirculated on Friday. “There was a reasonable case that the U.S. could continue to ‘muddle through.’ ”
Within weeks, Mr. Bernanke also began to insist that the failure of Lehman could not have been prevented without changes in federal law. Furthermore, some officials began to argue that the importance of the failure had been overstated because the economy was already falling apart.
“The whole framing, which seems to have hardened now, that the world ended with the Lehman bankruptcy is just deeply unfair to the basic truth,” Timothy F. Geithner, then the president of the Federal Reserve Bank of New York, said at an October meeting. “Independent of whether there was an option available at the time, the erosion in underlying economic conditions and in confidence in the future outlook was powerful and substantial going into August and early September.”
The Fed entered the year on edge. Officials did not know that the economy already was in recession, but Mr. Bernanke and his closest advisers worried that the Fed’s initial response to the financial crisis at the end of 2007 had been insufficient, and that tumbling stock prices were the beginning of a broader pullback.
Mr. Bernanke hoped to delay any action until the first scheduled meeting of 2008 in late January, but over the three-day Martin Luther King weekend, he concluded that the Fed could not wait. He convened a conference call at 6 p.m. on Monday, Jan. 21, and won agreement to cut the Fed’s benchmark interest rate 0.75 percentage point, the largest cut in more than two decades.
“The risk of a severe recession and credit crisis is unacceptably high,” Ms. Yellen said at the meeting.
Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said this week that the decision was an awakening. “If maybe we were a little slow to recognize what was happening, Martin Luther King weekend in January 2008 was a decisive point in terms of interest rate policy,” he said.
By early March, the Fed was moving to replace investors as a source of funding for Wall Street.
Financial firms, particularly in the mortgage business, were beginning to fail because they could not borrow money. Investors had lost confidence in their ability to predict which loans would be repaid. Countrywide Financial, the nation’s largest mortgage lender, sold itself for a relative pittance to Bank of America. Bear Stearns, one of the largest packagers and sellers of mortgage-backed securities, was teetering toward collapse.
On March 7, the Fed offered companies up to $200 billion in funding. Three days later, Mr. Bernanke secured the Fed policy-making committee’s approval to double that amount to $400 billion, telling his colleagues, “We live in a very special time.”
Finally, on March 16, the Fed effectively removed any limit on Wall Street funding even as it arranged the Bear Stearns rescue.
And then the Fed paused. By the end of April, it had cut short-term rates to 2 percent from 5.25 percent the previous September — one of the fastest falls in Fed history — and officials said they had done enough to shore up the financial system. They predicted that the economy would narrowly avoid a recession.
“I think it is very possible that we will look back and say, particularly after the Bear Stearns episode, that we have turned the corner in terms of the financial disruption that we have just experienced,” Frederic S. Mishkin, a Fed governor, said during a meeting at the end of April.
The summer passed relatively quietly. Officials began to fret about inflation. The transcripts include long conversations about when the Fed should start to raise interest rates.
“We saw growth of about 2 percent in the second quarter, which suggests a campaign slogan for the Republicans, ‘The Economy: It Could Be Worse,” Mr. Bernanke joked in early August.
But it was only the eye of the storm. By the third week of September, it was clear that Mr. Bernanke was right: Things could be worse. The financial crisis had arrived, as Ernest Hemingway once wrote of bankruptcy, “Gradually and then suddenly.”