Tuesday, March 04, 2014

Revisiting the Financial Crisis: Meeting of the Federal Open Market Committee on September 16, 2008 Part 2

This is part 2 of the my thoughts on the Federal Open Market Committee on September 16, 2008. You can read part 1 here. This meeting of the FOMC took place after Lehman Brothers filed for bankruptcy.

William C. Dudley had a laughably bad read of how the financial industry would react to the Federal Reserve not lowing the interest federal funds rates. This is the interest rate set by the Federal Reserve for banks lending to each other. Banks were desperate for credit after the Lehman Brothers announcement. Dudley thought banks would support the Fed not lowering the federal funds rates.

MR. DUDLEY. Well, I think the market participants would gain some comfort to the extent that the Federal Reserve as an institution indicates concern about what’s going on in the financial markets. But in some ways the Desk has already signaled that concern by its intervention, so I’m not sure that additional indications are needed. But in the language you might want to indicate to market participants that, if things were to materially worsen in the financial markets, the Committee might revisit the issue of where the federal funds rate should be.

Dennis P. Lockhart, the President of the Federal Reserve Bank of Atlanta, believed that the economy would start to recover in 2009.

With that as prologue, let me make just a couple of comments on regional soundings from the last couple of weeks. Anecdotal reports from the Sixth District support the view that the economy is quite weak but not deteriorating markedly. The CFO of a large retailer of housing-related goods said that they think they see a bottom forming. I am also starting to hear some reports that housing markets feel as though they are beginning to stabilize; but, really, it is a little too early to say that a bottom has formed in any of our housing markets. My overall sense from District contacts and our surveys is of an economy that is quite weak, with no clear trend evident.

Turning to the national outlook, like most forecasts, my view on the likely path for the economy has not changed materially since our August meeting. I see nothing in the data and hear nothing from District reports that alters my views that the second half will be very weak. I expect this weak period to be followed by a slow recovery gathering in 2009, but the foundation of a recovery starting around year-end or early 2009 may be far from solid. The contraction of credit availability that is confirmed by both surveys and anecdotal evidence could deepen as financial institutions face tight liquidity and difficulty recapitalizing. A protracted credit crunch would likely operate as a substantial drag on the economy.

The economic stimulus package, signed into law by President Barack Obama, helped keep a recession from turning into a depression. We can see that the unemployment rate ticked up after the September meeting of the FOMC.

Lockhart was also wrong in his prediction of the federal funds rate.

My view of the appropriate policy path is consistent with the Greenbook—that the fed funds rate target will remain stable at or close to the current level for several months going into 2009. My preference is to hold the fed funds rate at the current level of 2 percent. Among the reasons is that a ¼ percentage point drop, as suggested by alternative A, is really not clearly called for by a changed outlook for the real economy. Inflation risks are still in play, and I think we should give credit markets more time to digest events and sort out rate relationships.

The Federal Reserve changed course and have kept federal fund rates near zero percent. From the Federal Reserve website.

To support continued progress toward maximum employment and price stability, the Federal Open Market Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In its December 2013 statement, the Committee reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than half a percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In addition, at its December 2013 meeting, the Committee indicated that, based on its assessment of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments, it will likely be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

The Federal Reserve has kept fund rates near zero percent to keep credit moving between the banks. The fourth quarter of the 2008 was projected to have low GDP. Unemployment has showed signs of increasing. The housing bubble had popped. Banks were starting to go into panic mode after the Lehman Brothers bankruptcy. What was Lockhart thinking that the 2 percent federal fund rate could be maintained?

Future Federal Reserve chair Janet Yellen was correct in her projection unemployment and housing construction numbers would dip.

Recent data also suggest that labor markets are weakening across the board—a development that will cast a pall on household income and spending. The interaction of higher unemployment with the housing and financial markets raises the potential for even worse news—namely, an intensification of the adverse feedback loop we have long worried about and are now experiencing. Indeed, delinquencies have risen substantially across the spectrum of consumer loans, and credit availability continues to decline. One ray of hope is that the changes at Fannie and Freddie have caused a notable drop in mortgage rates. Another is that the decline in home prices has become somewhat less steep, and we have seen an outright improvement in home inventories relative to sales. But my contacts are very pessimistic about the prospects for nonresidential construction. They note that construction is continuing on projects in the pipeline with committed funding, but new projects are all but impossible to finance.

Unfortunately, Yellen mistakenly back keeping the federal fund rates at 2 percent.

What is fascinating is the FOMC was obsessed with inflation during the meeting. Inflation turned out to be the least of the America's economic problems in 2009. Inflation actually dropped to 1.1 percent in November of 2008 In December the rate was 0.1 percent. Inflation stayed below 3 percent in 2009.

Meeting of the Federal Open Market Committee on September 16, 2008 by Michael Robert Hussey

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