WASHINGTON – Federal Reserve officials in August 2007 remained skeptical that housing foreclosures could cause a financial crisis, just days before the Fed was jolted into action, according to transcripts that the central bank published Friday.
Worries about the health of financial markets dominated a meeting of the Fed’s policy-making committee on Aug. 7, but they decided there was not yet sufficient evidence that the problems were affecting the growth of the broader economy.
Just three days later, the Fed’s chairman, Ben S. Bernanke, convened an early-morning conference call to inform them that the central bank had been forced to start pumping money into a financial system that was suddenly seizing up. More than five years later, the system remains heavily dependent on those pumps.
“The market is not operating in a normal way,” Mr. Bernanke said on that August call, in a moment of historic understatement. “It’s a question of market functioning, not a question of bailing anybody out. That’s really where we are right now.”
August 2007 was the month that the Fed began its long transformation from somnolence to activism. Mr. Bernanke and his colleagues would continue to wrestle with misgivings about the extent of the Fed’s powers, and about the limits of appropriate action. At times they would hesitate or move slowly. At times they even would reverse course, most importantly in standing by as Lehman Brothers collapsed the following year. But it is now widely accepted that their efforts helped to arrest the economic chaos unleashed by the financial crisis.
Some of what followed might have been predicted by close readers of Mr. Bernanke’s work as an academic. He had long argued that the great lesson of the Great Depression was that a central bank should never allow its financial system to run short of money. Even more than its efforts to reduce borrowing costs, the Fed’s policy over the coming years would be defined by its determination to provide the funding private investors were withholding.
But in the face of an unprecedented crisis, Mr. Bernanke also would set aside his own work. He had long argued that the Fed should strive to respond to economic circumstances as transparently and predictably as possible, a break from the intuitive and unpredictable style of his predecessor, Alan Greenspan.
By the end of 2007, even as the available economic data remained fairly strong, Mr. Bernanke and his colleagues instead concluded that they could see the future, that they did not like what they saw, and that it was time to act.
“Intuition suggests that stronger action by the central bank may be warranted to prevent particularly costly outcomes,” Mr. Bernanke said in an October 2007 speech that marked the beginning of his public embrace of the need for pre-emptive action.
The Fed’s most dramatic steps did not begin until December 2007, when it created the Term Auction Facility, the first in a series of new programs intended to pump money into the financial system, and arranged to pump dollars into the European financial system in partnership with the European Central Bank.
And by January 2008, the Fed’s response to the crisis was in full swing.
The Fed began 2007 still deeply immersed in complacent disregard for problems in the housing market. Fed officials knew that people were losing their homes. They knew that subprime lenders were blinking out of business with every passing week. But they did not understand the implications for the broader economy.
”The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,” Mr. Bernanke said in March.
The mortgage industry was imploding by the time the Fed’s policy-making committee met on Aug. 7. American Home Mortgage, a leading subprime lender, had filed for bankruptcy the previous day. One week earlier, the investment bank Bear Stearns had liquidated a pair of mortgage-focused hedge funds. But officials did not cut interest rates. The economy, they said, “seems likely to continue to expand.” The statement did not even mention the housing market.
The transcripts show that many Fed officials at the August meeting remained deeply skeptical about the likely economic impact of those problems.
“My own bet is the financial market upset is not going to change fundamentally what’s going on in the real economy,” William Poole, president of the Federal Reserve Bank of St. Louis, told the committee on Aug. 7.
That was a Tuesday. The image of calm would last exactly two more days. By Thursday morning, the European Central Bank was offering emergency loans to continental banks and the Fed was following suit. And Mr. Poole and his board voted that day to ask for the Fed to reduce the interest rate on such loans, becoming the first official arm of the central bank to push for stronger action.
Two weeks later, at 6 p.m. on a Thursday, Fed officials dialed in to an emergency conference call where they agreed to adopt the St. Louis Fed’s proposal.
The central bank began to make it easier for cash-strapped financial companies to borrow money, an effort that would expand dramatically over the coming years as the crisis intensified and private investors withdrew funding.
