Central bankers these days seem to rule the world. While American legislators have become a byword for irresponsible economic stewardship in their “fiscal cliff” face-off, investors have become reasonably confident that Federal Reserve Chairman Ben Bernanke and European Central Bank President Mario Draghi will do what it takes to stimulate the US economy and save the euro, respectively.
But before the financial crisis, they didn’t look quite as wise.
On Jan. 18, the US Federal Reserve released hundreds of pages of transcripts from the monetary-policy decision meetings it held in 2007. In late 2006, economists had witnessed a significant slump in housing prices, some increases in foreclosures, and mortgage delinquencies. They had also seen some positive data. That picture changed in mid-August, when market conditions suddenly took a turn for the worse. Three days after the Fed’s meeting that month, it was offering emergency funding to provide liquidity for markets, which had all but dried up on its own.
Looking back, it’s pretty clear that none of them had a clue that a decline in the health of the housing market would snowball into a full-fledged financial crisis. Although many noted that they should keep an eye on housing, overall they were more worried about inflation risks for much of the year. While it’s true that the consumer price index (CPI)–the go-to measure of inflation–did spike right before the onset of the financial crisis, the importance of prices seems to pale in comparison with the fact that the system almost collapsed.
Hindsight is of course 20/20, but here’s what some of the country’s smartest economic minds were talking about just months before the fall of Lehman Brothers (pages noted are from each meeting’s transcript):
Michael Moskow, then President of the Federal Reserve Bank of Chicago, in January 2007 (p.39):
The housing markets look to be nearing the bottom, and the spillover to other sectors now seems likely to be minor or is being offset by other positive factors. Importantly, tight labor markets and lower energy prices are boosting consumer spending. We continue to expect that growth will be modestly below potential in the first half of the year, but like my business contacts, we expect activity to pick up in the second half and growth to be a touch above potential by 2008.
Gary H. Stern, then President of the Federal Reserve Bank of Minneapolis, in January (p. 41):
Mortgage delinquencies and foreclosures are rising, albeit starting from a fairly low level, and though that probably won’t have a significant effect on economic performance…As far as the national economy is concerned, it seems to me that the incoming data over the past several months underscore a couple of things. First, the data demonstrate, again, the underlying resilience of the economy. Second, they bolster the case for sustained growth over the next year or more, accompanied by steady to diminishing core inflation.
Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, in January (p. 54):
Declining housing construction is still depressing the real growth rate now, but demand has stabilized, I think, and inventories may be topping out. Each batch of housing data has bolstered my confidence in the trajectory we sketched out last fall—namely, that the drag from housing will mostly disappear by midyear with spillover having been relatively limited.
Timothy Geithner, then President of the Federal Reserve Bank of New York, in January (p. 68):
The overall balance of risks in our view is still weighted toward inflation—the risk that it fails to moderate enough or soon enough.
Cathy Minehan, then President of the Federal Reserve Bank of Boston in March (pp. 46, 48):
Trends in overall market and banking liquidity, mortgage interest rates, and new mortgage issuance are all positive. We think that those trends, combined with positive consumer home-buying attitudes, paint a reassuring picture that some of the downward trends will not be as severe as they otherwise might be…All in all, I remain somewhat more concerned about risks on the inflation side than about risks to growth.
Frederic Mishkin, then a member of the Board of Governors, in May (pp. 68-69):
The situation here is one about which I’m not super worried; but the environment is more complicated, and it makes our jobs more interesting. [Laughter] There is, of course, the Chinese curse that you should live through interesting times, but we’ll have more-interesting FOMC meetings…
Maybe I am a little less worried about the uncertainty and the downside risk, although I think they are still there, only because in the housing case, from the point of view of the longer-run fundamentals, I do not see a big problem. It really is an inventory-correction issue, which we are trying to sort out. That is creating uncertainty, but it creates more uncertainty in the shorter term rather than in the longer term.
Kevin Warsh, then a member of the Board of Governors, in May (p. 63):
My sense is that, after the fallout in subprime, the market is becoming more consolidated with larger, more-sophisticated lenders that can more quickly provide more markets that satisfy customers’ newest wants. The success in these markets of investment banks and hedge funds will go to those with scale, with strong distribution systems, and with control over their servicing businesses, so that they are effectively able to engineer workouts and avoid the need to foreclose.
Jeffrey Lacker again, in June (pp. 43-44):
So it looks to me as though we’re nearing a bottom in housing activity, albeit a bottom that may slope gently away from the steep cliff we descended last year. At this point, I think the risk of encountering another cliff has become relatively small…The good news on the real side, however, suggests that we are making progress toward seeing downside risks diminish enough for us to do something about inflation.
Charles Plosser, President of the Federal Reserve Bank of Philadelphia, in June (p.68):
The rise in long-term interest rates reflects the market’s upgrading of its assessment of the economy’s strength going forward. Indeed, as has been noted a couple of times, that uptick in long-term interest rates has been, I won’t say a worldwide phenomenon, but certainly widely spread in many countries around the world, which may be saying that global growth is more stable, predictable, and positive than perhaps we thought.
Thomas Hoenig, then Federal Reserve Bank of Kansas City, in August (p. 42):
I am not yet convinced, however, that recent financial market volatility and repricing of credit risk will have significant implications for the growth outlook. It is still reasonable at this point to think that the recent volatility will prove transitory, and the repricing of credit risk is, in that sense, desirable.
William Poole, then President of the Federal Reserve Bank of St. Louis, in August (p. 57):
My own bet is that the financial market upset is not going to change fundamentally what’s going on in the real economy.
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