“Foggy Recollections”

Cecchetti & Shoenholtz remember the 10th anniversary of Lehman:

The most intense period of the broadest and deepest disruption of U.S. and European finance since the Great Depression began with the failure of Lehman Brothers on September 15, 2008…

In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery.

First was the Fed’s aggressive monetary stimulus(!), including the introduction of unconventional policy tools, such as quantitative easing, targeted asset purchases, and forward guidance, at the effective lower bound for interest rates.

After Lehman, within its mandate, the Fed did “whatever it took” to end the crisis…

Let us backtrack a bit and see what propelled the economy towards Lehman and thereafter. I´ll tell a simple story, where the “leading actors” are nominal spending (NGDP) growth, real GDP growth, and oil prices. The “supporting actors” are inflation (headline & core) and the unemployment rate.

The charts show:

  1. During the first leg of the oil shock (Alan Greenspan), nominal spending (NGDP) growth remained steady.
  2. Resulting in a slight drop in RGDP growth (a natural result following a negative supply shock)
  3. Headline PCE inflation increased substantially. The strength and persistence of the oil shock showed some spillover into core PCE. Nevertheless, for the period average core inflation was exactly 2.0%.
  4. During the second leg of the oil shock (Bernanke), nominal spending (NGDP) growth was lowered. As this added a negative demand shock to a negative supply shock, real GDP growth dropped significantly.
  5. The fall in real growth, with a lag, began to affect the unemployment rate.
  6. During “The most intense period of the broadest and deepest disruption…), the aggregate demand (monetary policy) shock was so massive that even oil prices tumbled!

What was the Fed thinking?

The FOMC Meeting of September 16, 2008, was cavalier, although a Meeting could not have been more timely!:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending(!). Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy(!), combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

At least, unlike the June and August Meetings, there were no dissents.

A glimpse at the Transcripts of the September 16 Meeting indicate a high level of “hawkishness”:


My view of the appropriate policy path is consistent with the Greenbook—that the fed funds rate target will remain stable at or close to the current level for several months going into 2009. My preference is to hold the fed funds rate at the current level of 2 percent. Among the reasons is that a ¼ percentage point drop, as suggested by alternative A, is really not clearly called for by a changed outlook for the real economy. Inflation risks are still in play, and I think we should give credit markets more time to digest events and sort out rate relationships.


I also encourage us to look beyond the immediate crisis, which I recognize is serious. But as pointed out here, we also have an inflation issue. Our core inflation is still above where it should be. Headline inflation has been up, even though there are some signs that commodities and energy are backing off…

…So I would strongly encourage us to leave rates where they are, to be very careful with our language, not to encourage the expectation of further rate decreases, and to continue to be aggressive in our liquidity provisions as we have been the last several weeks and months.


With respect to policy, I would be inclined to keep the funds rate target at 2 percent today. For now, it seems to me that the additional liquidity measures that have been put in place are an appropriate response to the turmoil.


My policy preference is to maintain the federal funds rate target at the current level and to wait for some time to assess the impact of the Lehman bankruptcy filing, if any, on the national economy.


Given that my model is somewhat different from the staff’s model, I continue to believe that monetary policy at its current level is accommodative and that, if this current stance is sustained, the economy will experience faster inflation in the medium term.

Clearly, we must pay attention to the adverse effects of the financial disruptions. But we also must recognize that our policy actions today and over the next several months will affect the outcomes of inflation over the medium term. As I said, it is my view that the current stance of policy is inconsistent with price stability in the intermediate term and so rates ultimately will have to rise.


Overall, I don’t take what’s happened in the last few days as changing much. It’s not obvious to me what the implications are for the outlook for inflation and growth, at least at this point.

So I don’t see a reason to deflect from our policy path at this point. I can support standing pat with the funds rate today. I think that’s a good idea. I think, looking forward, that we will want to raise rates sooner rather than later if core inflation doesn’t moderate.

And from Chairman Bernanke:

As I said, I think our aggressive(!) approach earlier in the year is looking pretty good, particularly as inflation pressures have seemed to moderate.

Overall, I believe that our current funds rate setting is appropriate, and I don’t really see any reason to change. On the one hand, I think it would be inappropriate to increase rates at this point. It is simply premature.

We don’t have enough information. There is not enough pressure on inflation at this juncture to do that. On the other hand, cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward, and I think we should view that step as a very discrete thing rather than as a 25 basis point kind of thing.

However, three weeks later, on October 8, in a joint move with other central banks:

The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1/2 percent.

Bottom Line: Contrary to the Cecchetti & Shoenholtz´s view that the Fed, after Lehman, “did whatever it took”, “arresting the crisis and promoting recovery”; by further tightening monetary policy (letting nominal spending growth turn negative), the Fed caused the recession to become “Great”. Furthermore, as the chart indicates, there was never a “recovery”, with the economy embarking on a “slow boat” expansion.


1 Comment

  1. // Reply

    No one gets it better than Marcus Nunes

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