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Of course, we knew how difficult it is for economists to peer into the future. The Board’s research director, Dave Stockton, a fine forecaster of long experience, with an equally fine—and dark—sense of humor, reminded us what a messy business it was. “I thought I would invite you to don your hair nets and white butcher smocks and join me for a tour of the sausage factory,” he quipped, before discussing the analysis underlying the staff projections.

The Fed’s economic models, and economic forecasting models in general, do a poor job of incorporating the economic effects of financial instability, in part because financial crises are (fortunately) rare enough that relevant data are scarce. In 2007, Fed researchers were actively trying to overcome that difficulty by looking at other industrialized countries, like Sweden and Japan, that had relatively recently suffered significant financial crises. In discussing the challenges he and his team faced, Stockton reminded us of 1998, when staff forecasters had lowered their projections for U.S. economic growth in response to market turmoil triggered by the Russian debt default. But credit flows in the United States were not much affected and the economy weathered the storm. Six months after the onset of the Russian turbulence, the staff reversed course and revised forecasts upward.

“I think it’s fair to say that part of our mistake in 1998 was a failure to appreciate just how strong the U.S. economy was when we entered that period,” Stockton said.

As in 1998, staff forecasters had marked down their economic projections in response to the financial tumult, though only modestly. Were they on the verge of making the same mistake, projecting too much economic weakness as the result of financial stresses—or perhaps the opposite one, of projecting too little? The latest unemployment rate—4.6 percent in August—was still quite low despite the loss of jobs reported for the month. On the other hand, the financial disruptions now were showing up in mortgage lending, while in 1998 they had played out mostly in the stock and bond markets. The connection of house prices and mortgage availability to the Main Street economy was much more direct. Only about one in

five households owned stocks directly and even fewer owned bonds, while roughly two-thirds owned rather than rented their home. The ongoing decline in home prices and sales, by reducing construction and consumer spending, could slow the wider economy, which would lead to further weakening in housing, and so on. I warned that this vicious circle could unleash “the makings of a potential recessionary dynamic that may be difficult to head off.”

Rick Mishkin, from the same corner seat I had occupied when Greenspan was chairman, put it more bluntly: “Though we may not be allowed to mention it in public, we have to mention the r-word because there is now a significant probability of recession.”

Credit disruptions could spell trouble for the economy. But whether we were looking at something analogous to the Depression or something much milder was hard to determine. Thus far, the stress in credit markets seemed much more like the stress during the Russian debt crisis in 1998 than 1929. Indeed, for a while the New York Fed circulated a daily data comparison that suggested that the current crisis was effectively a replay of 1998. I was comforted that market volatility was still within the bounds of recent experience. But, with so much uncertainty about the outlook, I believed we needed insurance in the form of a larger than usual cut in the federal funds rate. Most of the hawks accepted that argument but wanted to make clear that the Committee wasn’t committed to further cuts. I insisted on a more forward-leaning message. “I think what the market wants to hear is that we get it, and that we’re here, that we are ready to move as needed,” I said.

As in August, we again discussed the issue of moral hazard—the notion, in this context, that we should refrain from helping the economy with lower interest rates because that would simultaneously let investors who had misjudged risk off the hook. Richard Fisher warned that too large a rate cut would be giving in to a “siren call” to “indulge rather than discipline risky financial behavior.” But, given the rising threat to the broader economy, most members, including myself, Don Kohn, Tim Geithner, Janet Yellen, and Mishkin, had lost patience with this argument. “As the central bank, we have a responsibility to help markets function normally and to promote economic stability broadly speaking,” I said.

While we went through with the larger than expected interest rate cut, we delayed taking action on another front. The blue-sky thinking that had emerged in August—and which had been carried forward by the staffs of the Board and the New York Fed—had resulted in a two-pronged proposal. The first was a proposed new facility that would auction twenty-eight-day discount window loans to banks, both U.S. and foreign, operating in the United States. This was the Board’s responsibility.

The second prong, which was under the authority of the FOMC as a whole, was currency swap lines with the European Central Bank and the Swiss National Bank. Through the swap lines, we could provide dollars to the two central banks, collateralized by euros and Swiss francs, respectively. The central banks could then lend the dollars to banks and other financial institutions in their jurisdictions. Having the ECB and the Swiss National Bank conduct auctions of dollar credit in parallel with ours should, we anticipated, reduce the pressures we were seeing in U.S. money markets—particularly in the morning

(East Coast time), when European banks were still open and were trying to borrow dollars in New York. Discussions with the Europeans on the details of coordinating credit auctions in the United States and

Europe—and the timing of the announcement—continued until the day before the September FOMC meeting. The ECB, in particular, was sensitive to any aspects of a currency swap arrangement that might imply that the Fed was riding to the rescue of European markets. We, in turn, wanted to avoid an incorrect inference that we were lending to potentially risky foreign private banks rather than creditworthy central banks. In light of the ECB’s diffidence and the modest improvements we were seeing in money market functioning, we chose to hold off. Both the auction program and the swap lines would remain on the shelf a bit longer.

Our September rate cut drew the usual mix of praise and criticism. The Wall Street Journal’s editorial writers sneered at it, without actually taking a stand for or against. The next morning, my old Harvard professor Martin Feldstein, whose gloomy presentation at Jackson Hole had caught Don Kohn’s attention, offered his congratulations for our having engineered a unanimous vote for a “bold and I think correct” move.

Barney Frank, the chairman of the House Financial Services Committee, and Chris Dodd, chairman of the Senate Banking Committee, both issued statements. Barney said he was pleased at the rate cut but displeased that the FOMC statement, in his view, still put too much weight on inflation risks. Dodd referred to an August 21 meeting he’d had with me and Hank Paulson in a way that seemed to insinuate that he deserved some credit for bringing pressure to bear on me. At the time I had told him that I was prepared to use every tool at my disposal, if necessary, and now, less than a month later, he was depicting my comment as an ironclad promise to cut the federal funds rate—not at all what I had intended. The Federal Reserve strives to make its decisions independently from political considerations, so I wasn’t particularly happy about the comments.

One potential critic of our interest rate cut was noticeably silent—Mervyn King, the governor of the Bank of England. In the summer of 2007, he had spoken in strong opposition to central bank interventions. In August, when the Fed and the ECB were trying to relieve financial strains by providing tens of billions of dollars and euros to the money markets, the Bank of England had remained on the sidelines. On September 12, in a report to the British parliament, Mervyn, without naming names, sharply criticized the ECB and the Fed. “The provision of such liquidity support . . . encourages excessive risk-taking, and sows the seeds of future financial crises,” he wrote. In other words, there would be no Bank of England put. Mervyn’s concern explained why the Bank of England had not joined the ECB and the Swiss National Bank in proposing currency swap agreements with the Fed.

By the time of our September 18 announcement, however, Mervyn appeared to have changed his mind. On the day after our meeting, the Bank of England for the first time announced it would inject longer-term funds (10 billion pounds, or roughly $20 billion, at a three-month term) into British money markets. Later in the crisis I observed, “There are no atheists in foxholes or ideologues in a financial crisis.” Mervyn

had joined his fellow central bankers in the foxhole.

The source of Mervyn’s conversion was the arrival of the global financial crisis on Britain’s High Streets. On September 14, the Bank of England had acted to stem a depositor run by lending to Northern Rock, a mortgage lender based in Newcastle upon Tyne, in northeast England. It was the first bank run in Great Britain since the infamous collapse of Overend, Gurney, and Co. in 1866, an event that had inspired Bagehot to publish his classic treatise. Northern Rock had expanded rapidly by raising funds in money markets and on the Internet rather than from local depositors. When the firm lost access to money markets and was unable to sell mortgages into a disappearing securitization market, it began to founder. The Bank of England agreed to lend to Northern Rock, but, when that was reported by the BBC, frightened depositors ran—a good illustration of the consequences of the stigma of borrowing from a central bank. Britain lacked government deposit insurance, relying on an industry-funded program that only partially protected depositors. Soon after the Bank of England’s intervention, the government announced it was guaranteeing all deposits at Northern Rock. In February 2008, it would take Northern Rock into public ownership.

TWO DAYS AFTER the FOMC meeting, on September 20, I testified before Barney Frank’s House Financial Services Committee, along with Hank Paulson and Housing and Urban Development secretary Alphonso Jackson. The subject was finding ways to stem the rising tide of mortgage foreclosures—a vital, and politically contentious, discussion. Foreclosures—especially foreclosures on homes financed by subprime mortgages with adjustable rates—had been rising for two years. We expected that foreclosures would continue to increase as the teaser rates on many mortgages reset at substantially higher levels. And with home prices falling, borrowers who had put little money down to buy their homes could no longer easily refinance to avoid the higher payment.

A few members of Congress pushed for direct federal aid to help homeowners in trouble, but most had little appetite for spending substantial taxpayer funds on the problem. The administration was doing what it could to reduce foreclosures without new federal spending. President Bush had recently turned to the Depression-era Federal Housing Administration (FHA) in an effort to help people who had recently missed payments on adjustable-rate subprime mortgages. Under the plan, those borrowers would be able to refinance into an FHA-insured fixed-rate loan with a lower payment. Mortgage insurance premiums from the borrowers, not the taxpayers, would pay the cost of the program. The president also had asked Hank Paulson and Alphonso Jackson to work on a private-sector foreclosure avoidance initiative, which would be called Hope Now. The administration ultimately enlisted lenders covering 60 percent of mortgages, investors, trade organizations, and mortgage counselors in a voluntary effort to keep borrowers in their homes.

At the Fed we did what we could, offering advice to the administration and Congress when we thought we could be helpful. I spoke often both within the Fed and in public about the urgent need to avoid

“unnecessary” foreclosures—those in which a reduction in the monthly payment or other modifications stood a good chance of keeping the borrower in the home. But, as a central bank without the authority to undertake fiscal spending programs, the Fed had only limited ability to help homeowners in trouble. At that point, our best available tool (other than pushing down short-term interest rates, which we were reserving for broader economic objectives) was our bank supervision powers. Earlier that month we had joined with other regulatory agencies in issuing supervisory guidance aimed at mortgage servicers. These companies, often owned by banks, collect monthly payments and forward them to the owners of the mortgages, including the owners of mortgage-backed securities. They also deal with delinquent borrowers, for example, by modifying payment terms or initiating foreclosures. We urged servicers to work with distressed borrowers. Because foreclosures cost time and money, and because foreclosed homes rarely resell for good prices, modifying troubled mortgages to keep borrowers in their homes could make sense for lenders as well as borrowers. Our message to the mortgage industry was that supervisors wouldn’t criticize them if they gave struggling homeowners a break. The Reserve Banks also worked behind the scenes in their regions, offering technical assistance and other support to the many nonprofit groups around the nation that were trying to counsel and help homeowners.

Unfortunately, institutional barriers and operational complexities sometimes prevented loan modifications that would otherwise make sense. For example, the legal agreements that governed many mortgage-backed securities required that most or all of the investors agree to a modification, a high hurdle. Many borrowers had taken out second mortgages with lenders other than the issuer of their first mortgage, and each lender was typically reluctant to offer a modification without concessions from the other. Servicers were overwhelmed by the volume of troubled mortgages, which require far more time and expertise to manage than mortgages in good standing. Servicers also received limited compensation for handling loan modifications, so they lacked both the incentives to undertake modifications and the resources needed to manage them effectively. And, of course, not all mortgages could be successfully modified. Certain borrowers could not make even substantially reduced monthly payments for reasons other than rate resets, including job loss, illness, or divorce.

As I had before, I pointed out at the hearing that modifying delinquent mortgages could benefit both lenders and borrowers, but there didn’t seem to be much consensus for action. Politically, averting foreclosures could be framed as protecting Main Street from Wall Street. But many voters evidently saw the issue as favoring irresponsible borrowers at the expense of the responsible.

A DAY LATER, Anna and I attended a party—in the courtyard of a stately mansion once the home of early nineteenth-century naval hero Stephen Decatur—for Alan Greenspan’s newly released memoir, The Age of Turbulence: Adventures in a New World. Greenspan, who largely avoided public encounters with thepress while in office, had promoted the book with an appearance on CBS’s 60 Minutes on the eve of the FOMC meeting. When asked by the interviewer about the Fed’s response to the financial crisis, he was

graciously evasive and said he wasn’t certain he would have done anything different and that I was “doing an excellent job.” I hoped he was right. I didn’t say it then, but as the financial crisis gathered steam, I couldn’t help but reflect on the irony of the title Greenspan chose for his book.

Financial conditions continued to improve modestly in the weeks after the September FOMC meeting. The rate cut and our earlier efforts to add liquidity seemed to have helped wholesale funding markets. And interest rates on interbank loans showed that lending banks felt a little more comfortable about the ability of borrowing banks to repay. The stock market continued to rebound—with the Dow closing at a record 14,165 on October 9.

Not all the news was positive. Wall Street analysts were abuzz with pessimistic speculation about upcoming earnings reports at large financial companies. And, on September 28, the Office of Thrift Supervision shut down NetBank Inc., founded in suburban Atlanta in 1996 as one of the nation’s first Internet-only banks. It was the largest savings and loan failure since the S&L crisis of the 1980s.

By the middle of October, the bad news Wall Street analysts had anticipated started to materialize. The credit rating agencies Moody’s and Standard & Poor’s continued to downgrade subprime mortgage– backed securities, and the prices of the securities continued their downward trek. During the week of October 15, three big banks—Citigroup, Bank of America, and Wachovia—reported steep declines in profits after write-downs of bad loans and mortgage-backed securities. The week ended with a stock market sell-off on Friday, October 19, the twentieth anniversary of the 1987 crash. The Dow fell 367 points to its lowest close since the day before the September 18 rate cut. It recovered somewhat in subsequent days, but the high-water mark reached earlier in the month would not be regained until years later.

A few hours after the market closed on October 19, Board member Kevin Warsh sent along a disturbing rumor that Merrill Lynch, a Wall Street securities firm overseen by the Securities and Exchange Commission, was about to report much greater losses than it had earlier previewed—an unusual event. Kevin saw the sharp revision as a bigger problem than the losses themselves. It suggested that credit markets were deteriorating so rapidly that even large financial firms were having difficulty valuing their holdings. On October 24, Merrill Lynch reported the biggest quarterly loss in its ninety-three-year history, $2.3 billion, and disclosed for the first time that it had $15 billion in complex collateralized debt obligations (CDOs)—backed by subprime mortgage securities—on its books.

As the name suggests, CDOs consisted of various forms of debt, which were bundled and sold to investors. CDOs were initially embraced as a means of providing enhanced diversification and tailoring the degree of risk to each investor’s preferences, but now they were suffering the same loss of confidence as other complex financial instruments. Merrill had created the CDOs to sell to investors, but it had kept some highly rated tranches of the securities for its own portfolio. Ratings no longer reassured potential buyers, and the values of the CDO tranches had fallen sharply. On October 30, Merrill CEO Stan O’Neal resigned.

AS THE OCTOBER 30–31 FOMC meeting approached, the key question—as in September—was how much would Wall Street turbulence hurt the “real” economy—where Americans worked, shopped, and saved for the future. Consumer spending was holding up surprisingly well. Except for housing, other economic bellwethers, such as new claims for unemployment benefits, had come in on the strong side, too. As at the previous meeting, the staff was projecting only a modest slowdown in economic growth.

The hawks on the Committee pointed to two developments that increased their anxiety. First, the foreign exchange value of the dollar had weakened (a trend that, if sustained, could make imports more expensive and raise inflation). Second, the day before the meeting, the price of crude oil had shot above $93 a barrel, which, after adjusting for inflation, broke a record set in 1981 during the oil crisis. Nevertheless, the staff’s inflation forecast hadn’t changed much. Dave Stockton explained that the dollar’s decline was not expected to have a lasting effect on import prices and that the staff expected energy prices to reverse course.

Considering the risks to both economic growth and inflation, we had two basic options for monetary policy. We could buy more “insurance” against the dangers posed by rocky credit markets with a further cut to the overnight interest rates. Or, we could lean against still worrisome inflation risks by standing pat and awaiting further developments. In a speech at the Economic Club of New York on October 15, I had been careful to avoid signaling either way. Nevertheless, the New York Fed’s latest survey of Wall Street firms suggested that markets expected a quarter-point cut.

I told the Committee that the decision was a “very, very close” call for me. I acknowledged that inflation was a concern and said the markets could probably withstand the surprise if we held our target rate steady. But I came down on the side of cutting the rate. “The downside risks are quite significant, if the housing situation, including prices, really deteriorates,” I said. However, in a concession to the hawks that I would later regret, I agreed to a shift in language that signaled we weren’t eager to cut rates again absent a change in the data. We cut the federal funds rate to 4-1/2 percent and said that, with that action, “the upside risks to inflation roughly balance the downside risks to growth.” Tom Hoenig of Kansas City dissented anyway. He said it was easy to cut rates, often a popular move, but difficult to raise them later if you have made a mistake. The balanced-risks language was enough to satisfy the other hawkishly inclined voter, Bill Poole of St. Louis. The vote in favor of the action and statement was 9–1.

AFTER THE FOMC announcement, Chris Dodd—who was then seeking the Democratic Party nomination for president—again issued a statement implying a link between our action and his August meeting with Paulson and me. That irritation aside, in late 2007 and into 2008, my greater concern was that Dodd was sitting on three Federal Reserve Board nominations. The president in May 2007 had nominated Betsy Duke, a community banker from Virginia Beach, and Larry Klane, a senior executive of Capital One Financial Corp., to fill two vacancies on our seven-member Board. With the departure of Mark Olson in June 2006 and Sue Bies in March 2007, the Board not only was short-staffed, we also had no one with

practical banking experience. Incumbent Randy Kroszner, meanwhile, had been nominated for a new fourteen-year term. He had been serving out Ned Gramlich’s term, which would end on January 31. The three nominees had had a joint confirmation hearing before the Senate Banking Committee on August 2, but Dodd had shown no inclination to allow the nominations to proceed.

By September 26, I knew that we were going to have to deal with uncertain financial and economic prospects without a full Board. Brian Gross in the Fed’s legislative affairs office had talked to Betsy, who had heard about a comment by Dodd that there was “no way all three nominees are going to be confirmed.” Brian, who had long experience in Washington, looked at the glass as at least one-third full. “By ruling out ‘all three nominees,’ I think it does rule in at least one,” he said in an email. In the meantime, though, Dodd let the nominees dangle.

As the months passed, living in nomination limbo wore on Randy. By law, even after his term expired, he could continue to serve until someone else was confirmed in his place. But it was hard to feel like a full member of the Board under those circumstances. Randy was filling an important role in overseeing the Fed’s efforts to improve its banking supervision and consumer protection. And with the nominations apparently on hold, we couldn’t afford to lose another Board member. I would invite him to a symphony at the Kennedy Center in January and try to buck up his morale. Since the Fed opened its doors in 1914 the Board had never had fewer than five members in office. Around the same time, I was also worried that we would lose Rick Mishkin. Rick had asked whether he could, while serving at the Fed, work on a new edition of his very well-regarded (and lucrative) textbook on money and banking. The answer from the Office of Government Ethics was no. I asked if he would consider staying on nevertheless.

Both Randy and Rick were important contributors to the Board’s work—but I faced a procedural challenge in ensuring that their views were heard. Federal open-meeting laws regard any gathering of four or more Fed Board members as an official meeting. Any such interaction must be both publicly announced and, unless certain requirements are met, open to the public. Don Kohn, my vice chairman, with his long experience at the Fed, and Kevin Warsh, with his many Wall Street and political contacts and his knowledge of practical finance, were my most frequent companions on the endless conference calls through which we shaped our crisis-fighting strategy. Tim Geithner, as president of the New York Fed, was also involved in most of our discussions, but not being a Board member he didn’t trigger the open-meeting law. Inviting Randy or Rick to join these conversations would have made the calls official meetings subject to the sunshine law—not a great venue for blue-sky thinking and strategizing. I tried to keep Rick and Randy apprised of developments through one-on-one lunches and frequent email exchanges.

IN THE OCTOBER FOMC meeting we also discussed the first substantial step toward my most cherished pre-crisis priority—making the Fed’s monetary policy process more transparent and systematic. I had long advocated that the Fed adopt flexible inflation targeting—a strategy that set a specific target for

inflation but also respected the maximum employment part of our mandate. Finally, I was in a position to do more than talk.

Early in my chairmanship, I had asked Don Kohn to lead a subcommittee of the FOMC to evaluate ways the Fed could improve its monetary policy communications, including, perhaps, by adopting an inflation target. In 2003, Don and I had taken opposite sides on inflation targeting at a symposium at the Federal Reserve Bank of St. Louis. But Don had described himself as a skeptic rather than an opponent. If Don, who commanded enormous respect from his colleagues, could find ways to alleviate his own concerns, he would move toward my position and others would follow.

Don’s group included Janet Yellen, whose experience as a monetary policymaker extended back to a term on the Board in 1994–96, and Gary Stern, who was then the longest-serving Reserve Bank president, having been at the helm in Minneapolis since 1985. The subcommittee stopped short of recommending that we formally adopt inflation targeting. But, based on its work, reviewed by the FOMC in June 2007, I proposed moving in that direction by publicly releasing numerical information about what Committee members meant by “price stability” and by publishing more extensive and more frequent economic projections. The two steps, in combination, would help markets form more accurate expectations about future monetary policy and the path of interest rates.

The FOMC had been releasing economic projections since 1979 as part of its twice-a-year report to Congress. Don’s subcommittee had looked at doubling the number of forecasts to four a year and releasing them more quickly. The subcommittee also had examined a subtle but significant step toward a formal inflation objective—extending the forecast period for economic growth, inflation, and unemployment to three years, from two. At least under normal circumstances, three years is enough time for monetary policy to achieve (or come close to) the Committee’s desired level of inflation. By announcing a forecast for inflation three years out, the Committee would effectively be telling the world its numerical target for inflation. It was indirect, but I was confident that market participants would understand the point.

Don’s subcommittee hadn’t forgotten about the employment half of the Fed’s mandate. That issue, however, was more complicated. Ultimately, inflation is determined almost entirely by the tightness or ease of monetary policy, so the FOMC could target the inflation rate at whatever level we thought made most sense. The maximum sustainable level of employment, however, is determined by a host of factors— ranging from the demographics of the labor force, to the mix of workers’ skills, to technological developments—and cannot be arbitrarily set by monetary policymakers. As an additional complication, economists cannot know the maximum sustainable level of employment with any certainty but must estimate it based on historical experience. Having a fixed employment target in parallel to the fixed inflation target was consequently not feasible. Nevertheless, monetary policymakers’ predictions of the unemployment rate three years out would at least give a general sense of what level of employment policymakers thought they could achieve without generating inflationary price and wage increases.

Date: 2016-04-22; view: 655