The View From 1776

The Fed failed completely to foresee the 2007-2008 housing meltdown and the collapse of the financial system.  The Fed failed completely to foresee the dot.com boom-and-burst that threw the economy into recession at the end of President Clinton’s tenure.  The Fed failed completely to foresee the stagflation of the 1970s (it was, in fact, proclaiming its success at fine-tuning the economy using Keynesian economic tactics).  The Fed pumped up the money supply sharply during the 1920s, failing completely to foresee the 1929 stock market crash and the Great Depression.

The following excerpts from an article in today’s Wall Street Journal bring us up to date on the dangerous folly of allowing the Fed to attempt management of the economy, particularly when it espouses the Keynesian belief that financing the government’s deficit spending will automatically end a recession without inflationary distortions to people’s standards of living.

Fed 2006 Transcript Highlights: Riding Housing Roller Coaster With Eyes Shut

Federal Reserve Chairman Ben Bernanke and most of his colleagues showed little concern when house prices started to decline in 2006, predicting “a soft landing” in the then-strong U.S. economy, transcripts from the central bank released Thursday show.

Bernanke, who took over from Alan Greenspan as Fed chairman in February 2006, is cautious in making forecasts about housing and the wider economy. But, together with then New York Fed chief Timothy Geither, he believes the slowdown in housing is healthy and likely to end well.

MAR. 27-28: In Bernanke’s first meeting as Fed chairman, housing looms as a risk, but officials haven’t grasped the severity of the threat. The Fed’s chief economist, David Stockton, offers some ominous warnings. “Right now, it feels a bit like riding a roller coaster with one’s eyes shut,” when discussing his forecast for a modest slowdown in housing. “We sense that we’re going over the top, but we just don’t know what lies below.” Later, he notes that housing is “the most salient risk” to the economy. “I just don’t know how to forecast those prices,” he says of housing prices.
“Again, I think we are unlikely to see growth being derailed by the housing market, but I do want us to be prepared for some quarter-to-quarter fluctuations,” Bernanke says. He identifies housing as a crucial issue, but adds that he agrees “with most of the commentary that the strong fundamentals support a relatively soft landing in housing.
Timothy Geithner, who is now Treasury Secretary and was then president of the Federal Reserve Bank of New York, doesn’t see the parallel risks building in the financial system. “Equity prices and credit spreads suggest considerable confidence in the prospect for growth,” he says. “Overall financial conditions seem pretty supportive of the expansion.”
In terms of policy, Bernanke picks up where predecessor Greenspan left off: with another quarter-point boost in interest rates, and a hint of more to come.
But he puts a modest stamp of his own on the Fed’s closely watched post-meeting statement, by including a more explicit view of where the nation’s economy is headed. The statement’s forecast that economic growth appears likely “to moderate to a more sustainable pace” may be an early, though small, sign of his efforts to make the central bank’s thinking more transparent.

MAY 10: Fed officials spend a lot of time discussing rising energy prices and risks to inflation and agree to raise short-term interest rates by 0.25%. Susan Bies, a Fed governor, tries to bring the discussion back to housing and her growing worries about mortgages. She looks enlightened in retrospect in a discussion about the risks that increasingly exotic mortgages pose to consumers and banks.
Bies points in particular to negative amortization loans, in which household loan balances get bigger and not smaller over time. “I just wonder about the consumer’s ability to absorb shocks,” she warns. “The buildup of home equity and the ability to borrow against it have helped individual homeowners when they have had layoffs, medical problems, divorces-all the things in life that create month-to-month problems for cash flow. With the growth of negative amortization, home equity is not being built up anymore.” She sums up with a ominous warning: “The growing ingenuity in the mortgage sector is making me more nervous as we go forward in this cycle, rather than comforted that we have learned a lesson. Some of the models the banks are using clearly were built in times of falling interest rates and rising housing prices. It is not clear what may happen when either of those trends turns around.”
Bernanke acknowledges the risks, but doesn’t sound overly worried: “So far we are seeing, at worst, an orderly decline in the housing market; but there is still, I think, a lot to be seen as to whether the housing market will decline slowly or more quickly. As I noted last time, some correction in this market is a healthy thing, and our goal should not be to try to prevent that correction but rather to ensure that the correction does not overly influence growth in the rest of the economy.”

JUNE 28-29: In summarizing Fed officials’ views, Bernanke notes how it’s getting more and more difficult to make forecasts, describing the economic situation as “exceptionally complicated.” Since housing is particularly hard to project, Bernanke calls it “an important risk and one that should lead us to be cautious in our policy decisions.”
The Fed raises interest rates to 5.25% from 5% at this meeting, the 17th increase in a row. But for the first time since it began raising rates from a low of 1% in June 2004, the Fed doesn’t explicitly say another rate increase was under consideration.
AUG. 8: Bernanke reminds his colleagues that the Fed has not been “terribly successful with soft landings” in the economy. Then he adds: “We have a chance to get one.” Janet Yellen, the Fed vice chairwoman who headed the San Francisco Fed in 2006, appears to be the most concerned about housing, warning that the housing slowdown could become an “unwelcome housing slump.” The central bank leaves rates unchanged at this meeting after two years of steady increases. Geithner wants to cite housing weakness as a factor, but the majority is against that.
SEP. 20: The Fed cites housing and energy declines in holding interest rates steady. However, chief economist Stockton says that the economy “bends but doesn’t break” under one Fed forecasting scenario of a housing slump. “So far the collateral damage from the downturn in housing has been limited, and for the most part, we expect it to remain that way, at least for a time,” he says. Bernanke notes there’s a split on how housing is viewed at the Fed, with some expecting a deep correction while others believe incomes and rates will support housing. Here’s how he sums it up: “the economy except for housing and autos is still pretty strong, and we do not yet see any significant spillover from housing.”
At points, some officials played down the housing and mortgage threats. “As one CEO told me, the only subject that has been more analyzed than the housing situation is the birth of Brad Pitt’s baby,” Dallas Fed president Richard Fisher said in the September meeting. “According to this view, if we have not discounted what has been happening in the housing market, we have been living on Mars, and I think that is an important point to take into account.”
Asked to comment Thursday, Mr. Fisher noted that he wasn’t dismissive of the threat. In that same September meeting, for instance, he noted that he was more pessimistic about the housing outlook than was the Fed’s economics staff in Washington. The previous month he noted that one homebuilder said the housing correction was the “roughest and most sudden” he had seen.

DEC. 12: The meeting that closes out the year sees policymakers showing little rising awareness of the storm coming their way. Indeed, much of the conversation officials have was about employment and inflation. Some of the evidence of rising weakness in housing was seen largely as a correction for past excess, rather than the genesis of the worst financial crisis since the Great Depression.
Boston Fed boss Cathy Minehan then observes her district was seeing a slowdown in housing, but she saw no great concern in this development. The Richmond Fed President Jeffrey Lacker notes a mixed housing picture: he doesn’t see any great catastrophe coming the sector’s way. Cleveland Fed leader Sandra Pianalto flags some borrowers’ increased difficulty in getting mortgages in her region. Then Fed Vice Chairman Donald Kohn says rising inventories in manufacturing was “a bit more troubling” than the cooling in housing activity he’d seen.
Fed Governor Bies once again looks ahead of the curve. She says “the amount of leverage in each housing deal may still need some correction going forward, and so we may see some slowdown in the volume of dollars that are funded through mortgage lending.” She also says that in markets there is a realization “that a lot of the private mortgages that have been securitized during the past few years really do have much more risk than the investors have been focusing on.”
Bernanke fails to see any major problem brewing in housing based on his comments in the transcripts, once again predicting a “soft landing” for the economy.