In FED We Trust (20 page)

By the time the FOMC convened in Washington on September 18, a couple of weeks after Jackson Hole, the government had reported that employers had cut their payrolls for the first time in seven years. Britain had witnessed its first bank run in a century, humiliating Mervyn King at the Bank of England. King had chided the Fed and ECB for rushing to pump money into credit markets. Doing so “encourages herd behavior and increases the intensity of future crises,” he charged. Then in response to a run on a bank misleadingly named Northern Rock — which employed a Countrywide-like strategy of borrowing in short-term markets to finance mortgages that it planned to sell to securities markets — King had been forced to do in the markets what other central banks had. In Washington, the ghost of Greenspan loomed as he released his memoir with an appearance on
60 Minutes
, an excerpt in
Newsweek
, and headlines nearly everywhere days before the FOMC meeting.

Bernanke didn’t need a cudgel to persuade the FOMC to cut interest rates. Reducing short-term interest rates was traditionally the Fed’s best weapon against the prospect of an unwelcome weakening of the economy, and there was no reason — yet — to doubt they’d be ineffective. The only issue was how much to cut.

Financial markets and the Fed play a constant mutual guessing game. Traders, analysts, and investors scrutinize the Fed’s words, the whispers they hear from people who seem to talk to folks at the Fed, and accounts in the press. Out of that stew of speculation and innuendo, the markets gauge the likely reaction of Fed officials to incoming data on the economy, and move market interest rates in anticipation of the next Fed maneuver. The Fed, in turn, looks to markets for the collective judgment of huge numbers of people with money
about the likely direction of the economy — even though Fed officials know that looking at the markets is sometimes like looking in a mirror and seeing what the market thinks the Fed is planning to do. Finally, after both sides have studied each other, bets are placed on which way the Fed is going to move, often in the federal funds futures market. In September, the betting was that the Fed would cut its target, then at 5.25 percent, by a quarter percentage point.

Despite the misgivings of some regional bank presidents, the Fed delivered a rate cut twice that size. The stock market cheered the news loudly. The Dow Jones Industrial Average had its best day since 2003, rising 2.5 percent. In Fedspeak, the aggressive half-point move amounted to “taking out insurance,” preemptively cutting interest rates to reduce the risk of a nightmare scenario becoming reality. Especially in the wake of the run on Northern Rock, the Fed needed — as Geithner often put it — to get the ratio of drama to impact right. Too much drama, and the Fed conveyed unsettling panic. Too little action, and the Fed looked wimpy. The September rate cut was one instance in the Great Panic where the Fed appeared to hit the ratio exactly right. The first rate cut of Bernanke’s tenure was a clear success.

Yet despite the deft touch, surprising numbers of ordinary Americans were angry, and getting more so. They saw the Fed helping Wall Street and irresponsible home buyers. “The Federal Reserve needs to stand its ground and not bail out hedge funds — they should have known better to begin with!” Suzanne Mitchell, an administrative assistant at a Houston real estate company, told the
Wall Street Journal
. “I’m very sorry that people took out $450,000 mortgages with no money down … people ought to be responsible for the loans they take out.”

An angry public aside, the Fed had reason for optimism in September and October 2007. In the weeks that followed the rate cut, the economy and markets did better than Fed officials had expected. So the Fed put aside plans, discussed in the back room in Jackson Hole in August, to experiment with new ways to lend money to banks. Cutting interest rates and the few modest
other steps the Fed had taken to provide liquidity seemed sufficient. Banks had taken a blow, for sure, but Bernanke and Geithner believed banks had begun the Great Panic with enough capital to absorb the anticipated losses.

At a closed-door workshop on financial stability in Washington in October, Geithner said that though it was too early to tell how well the system was functioning in this crisis, one thing was encouraging: “The capital cushions at the largest banks proved strong enough to withstand the shock. … This was absolutely critical.” (He was wrong.)

Bernanke was just as reassuring when he appeared before the New York Economic Club, a group of Wall Street economists, executives, and traders. “Fortunately, the financial system entered the episode of the past few months with strong capital positions and a robust infrastructure. The banking system is healthy,” he said. It was not one of his more prescient observations, but where the Great Panic was concerned, almost no one got a gold star for guessing the future right.

Bernanke wasn’t in a Pollyanna mode. He had plenty of worries, but they were more question marks than alarm bells. Prompted by a question from Henry Kaufman — nicknamed Dr. Doom for his gloomy predictions while at Salomon Brothers years earlier — Bernanke told the Economic Club that one issue was the difficulty Wall Street was having in valuing securities, particularly those linked to mortgages. With so little trading, market prices were nonexistent or possibly misleading. What information did Bernanke most wish he had that he lacked? Kaufman asked. “I’d like to know what those damn things are worth,” the chairman replied.

The response drew a laugh, but it turned out to be far more profound than it sounded at the time. The difficulty in putting a value on loans, securities, and exotic financial instruments banks were carrying on their books became one of the most debilitating features of the Great Panic. With the usual market mechanisms dysfunctional, no one could be sure the assets were properly valued — and that all the losses had been disclosed — so everyone assumed the worst, a problem that would persist into 2009. But in the fall of 2007, the Fed didn’t yet appreciate just how big an issue that was or would become.

“The mistake I made was to think about the damage being primarily limited to subprime lending,” Bernanke would admit later. “After all, the sub
prime losses involved an amount of money equal to one day’s movement in the stock market, and that isn’t enough to make a big difference in the economy,” he said, with the perspective that comes only with time. “But we know now this was much bigger than subprime lending. It was a credit bubble much more broadly construed. The subprime crisis triggered a much broader retreat from credit and risk taking. It became a much bigger deal than I anticipated. And on top of that, we didn’t — nobody really did — understand the interconnections to off — balance sheet vehicles and complex credit derivatives and all those other things that followed.”

All that, though, was by way of retrospection. By the end of October, the economy seemed to be gaining traction. Fed officials saw “scant evidence of negative spillovers from the ongoing housing correction to other sectors of the economy.” Instead, they predicted the economy would rebound to normal growth in 2009. Mishkin’s histories of financial crises found that they often turned around after three or four months. Why shouldn’t that happen this time, too? At the October 31 FOMC meeting, Bernanke led the majority to a one-quarter percentage point cut and an end-of-meeting statement that indicated the Fed thought it was done with rate cuts for a while. That, too, would prove a widely overoptimistic assessment.

While economists on the outside worried that the Fed was doing too little, some regional Fed bank presidents thought Bernanke was doing too much. Among those arguing for holding interest rates steady was a band of central bankers from the middle of the country derided by their internal foes as “presidents from the flyover states.” One of them, Thomas Hoenig, longtime president of the Kansas City Fed, said that the U.S. economy was growing at “a reasonable pace” on its own and didn’t need the Fed’s ministrations. By lowering rates to cure what didn’t need curing, the Fed instead had “elevated” the risk of inflation, he said. By law, only five of the twelve district bank presidents vote on rates at any meeting; Hoenig was one of the five and thus allowed to formally object to the rate cut.

Fed officials are the Jewish mothers of the global economy. They always have to worry about something, and that something is often inflation — not today’s inflation, but the possibility of inflation tomorrow. It’s no idle concern: when the Fed took its eye off that ball in the late 1970s, the United States ended up with debilitating double-digit inflation. In late 2007, Hoenig and others were worrying that the Fed had taken its eye off the inflation ball again. Oil prices were rising, and he and the like-minded feared that would lead companies and consumers to anticipate price increases throughout the economy, an anticipation that often becomes self-fulfilling. The U.S. economy wasn’t so weak that it would prevent wage and price increases, the inflation-wary feared, and the world economy wasn’t weak at all.

In Fedspeak, Hoenig was a hawk, while Boston’s Rosengren and San Francisco’s Yellen were doves. The labels were used loosely to distinguish between Fed officials who tend to favor higher interest rates to ward off any risk of inflation and those who tend to favor lower rates to head off higher unemployment. Economic forecaster Laurence Meyer, a keen observer of the Fed who spent five years on Greenspan’s Fed board, noticed that traditionally hawkish FOMC members minimized the risks to the economy from financial turmoil, while dovish members tended to emphasize the risks — even though issues of financial stability had little in common with the usual inflationary dynamics.

“The hawks are very passionate in their views about the appropriate course of monetary policy and tend to speak with loud voices, both in their speeches and inside the FOMC,” he wrote to clients in a memo that circulated widely within the Fed. “The doves … tend to be stunned by the belief of the hawks that the credit shock does not have to be offset by easier monetary policy.”

“Call it a genetic predisposition,” he said.

That internal divide would plague Bernanke throughout the Great Panic, particularly when the Fed began to devise new ways to lend money.

October proved a false dawn. As financial stresses resurfaced in November, Rick Mishkin — who wasn’t by nature patient — grew antsy about the inadequacy
of the Fed’s response. A scholar of financial crises of the past, Mishkin finished his Ph.D. at MIT a few years ahead of Bernanke and, in 1983, landed a teaching job at Columbia. Except for a brief stint at the New York Fed in the mid-1990s, where he was recruited to strengthen a lackluster research department, Mishkin had become a fixture at Columbia in the years since, authoring a college textbook on money and banking that dominated the market and sweetened his personal finances. (Mishkin disclosed $434,000 in royalties in 2007, more than double his Fed salary of $172,200. He left the Fed in August 2008, largely because government ethics rules wouldn’t permit him to revise his textbook while remaining in office. By the end of 2008, he already had revised the chapter on financial crises to refer to this latest one.)

Mishkin thought of himself as entertaining — and sometimes was. Despite uneasiness among the Fed’s public relations staff, he titled one speech “Comfort Zones, Shmumfort Zones,” an uncomplimentary reference to an alternative to inflation targeting that called for the Fed to set a vague “comfort zone” for the acceptable level of inflation. “Putting the ‘shm’ before a word is a way to cast a bit of skepticism on it,” he explained to a Lexington, Virginia, audience unaccustomed to Yiddish-spouting New Yorkers. “Thus, if your friend tells you that you are ‘fancy, shmancy,’ then you might be overdressed for the occasion. …Of course, there’s also a significant distinction between the expressions ‘shlemiel’ and ‘shlimazel,’ but that’s more advanced material that I will defer until another speech.”

Mishkin had been close to Bernanke professionally and personally before arriving in Washington seven months after Bernanke assumed the chairmanship — three of the twelve references in Bernanke’s first published paper cited Mishkin. And Mishkin remained unswervingly loyal to his friend. Excluded from the Four Musketeers, he resorted to one-on-one meetings with Bernanke to try to influence him directly. Frustrated at the FOMC’s inertia and the caliber of some of the discussions, Mishkin eventually decided that public speeches might have a bigger influence inside the Fed than arguments he made at the Fed’s closed-door meetings. Speeches, after all, could be cited by outsiders, giving them credibility with insiders, and they could be contemplated outside the meeting room.

Better still, well-conceived phrases in speeches could frame debates at the
Fed. In the 1990s, Greenspan repeatedly described banks’ reluctance to lend as “50 mph headwinds” holding back the economy, and those headwinds became the justification for cutting interest rates. Mishkin’s contribution a decade-plus later was a wonky phrase: “adverse feedback loop.” The notion was that financial disruptions hurt consumer spending and business investment. That, in turn, made lenders and investors more cautious, which led to an even worse economy.

The notion wasn’t original; Bernanke’s “financial accelerator” concept was much the same thing. But neither the phrase nor the policy it implied — sharply lower interest rates — caught on when Mishkin began using it in internal debates in the fall of 2007. He didn’t give up, though. After he dropped “adverse feedback loop” into a November 5, 2007, speech, it got more attention — though not immediate endorsement. Two days later, for example, the Atlanta Fed’s Dennis Lockhart cited it in a speech before dismissing the idea as being “quite unlikely.” A few months later, though, in February 2008, Lockhart would use Mishkin’s argument to defend the Fed’s dramatic cuts in interest rates, and Janet Yellen, the San Francisco Fed president, would declare that mitigating the possibility of an adverse feedback loop was a major Fed objective. And in June 2008, the whole FOMC cited the loop as “a worrisome possibility” in its economic forecast.