Federal Reserve economists warned in December 2008 that five years could pass before growth revived enough to warrant raising interest rates from near zero, as the magnitude of the economic meltdown dawned on Fed officials.
The warnings, part of preparatory documents for policy meetings in 2008 released by the Fed yesterday, highlight the sudden alarm among central bank staff as the economy began to plunge in the worst downturn in seven decades. Six weeks earlier, the economists had predicted a contraction of no more than 1 percent and said the Fed could restore growth by lowering the main rate to 0.5 percent before tightening in 2010.
By the time of the Dec. 15-16 meeting, Fed staff warned that the central bank would simply be unable to “provide enough stimulus to generate a robust recovery with a relatively quick return of inflation and unemployment to desired levels.”
The briefing documents, along with transcripts released last month of the 2008 meetings of the Federal Open Market Committee, reveal the extent of the economic tailspin confronted by Chairman Ben S. Bernanke. They show why policy makers that December pushed down the main interest rate to zero and backed asset purchases that have since expanded the Fed’s balance sheet to $4.17 trillion.
The Fed’s delayed reaction provoked congressional criticism that persists today. Fed Chair Janet Yellen in testimony to the Senate Banking Committee on Feb. 27 tried to deflect a lawmaker’s comment that FOMC officials in the second half of 2008 were slow to wake up to the magnitude of the recession.
Policy makers in September 2008 “did not realize just how serious the deterioration in both the financial markets and the economy was about to get,” she said.
“I was one of those who was urging more, faster, we need to get on this,” said Yellen, who joined FOMC discussions that year as San Francisco Fed president. By December, the FOMC “had certainly changed its focus.”
Bernanke gave voice at the December meeting to the FOMC’s change of heart.
“We are at a historic juncture, both for the U.S. economy and for the Federal Reserve,” Bernanke said before winning a unanimous decision from the FOMC to reduce interest rates to zero. “The financial and economic crisis is severe despite extraordinary efforts not only by the Federal Reserve but also by other policy makers here and around the world.”
The Fed’s staff in 2008 prepared briefing documents for the committee that underpinned Bernanke’s outlook. At each meeting they provided a so-called Greenbook with economic forecasts and the Bluebook with monetary policy options. The briefing materials have since been combined into a single Teal Book.
An additional briefing document, the Beige Book, provides anecdotal accounts of the economy and is released to the public before each FOMC meeting.
The December 2008 briefing materials reveal what the Fed staff got right and wrong.
The Fed’s economists didn’t foresee how sharply growth would decline, and how slowly it would recover. A baseline simulation in the Green Book for December said the economy would shrink less than 3 percent at the worst point of the recession, and would recover to around 6 percent growth in 2013.
The economy shrank 4.1 percent in the four quarters through 2009, and has notched year-over-year growth of no more than 3.3 percent during the recovery.
The Fed forecast the unemployment rate would climb to 8 percent in its baseline, or above 9 percent in a scenario with more financial stress. The unemployment rate peaked in 2009 at 10 percent. They predicted unemployment would then fall every year by about 1 percentage point.
The Fed’s staff is led by three division directors who are responsible for compiling the briefing documents. In 2008, those directors were Brian Madigan for monetary affairs, David Stockton for research and statistics and Nathan Sheets for international finance.
Not all of the Fed staff’s forecasts were too optimistic. They predicted the central bank would be unable to return inflation toward 2 percent, with their baseline predicting inflation of between 0.5 percent and 1 percent at the end of 2013, as measured by the Fed’s preferred gauge, the personal consumption expenditures price index, excluding food and energy.
The index measured 1.2 percent at the end of December.
Also, they accurately predicted the central bank would have to keep interest rates near zero for years.
Their forecasts also show skepticism about the power of unconventional policies such as bond purchases and forward guidance about interest rates, the two strategies the central bank has pursued to provide stimulus.
One sidebar on the implications of unconventional policy in the December Bluebook concluded that bond buying and forward guidance could lower unemployment by about 0.25 percentage point to 0.5 percentage point.
“The economic effects of this particular example of unconventional policies are modest, but the estimates are subject to considerable uncertainty,” the staff wrote in the briefing material.