Anticipating and responding to a financial crisis: Federal reserve policy in 2007-2008

At the start of 2007, the Federal Reserve System hoped that it had successfully engineered the “soft landing” that everyone desired: a declining inflation rate without a recession.  The “business as usual” attitude at the Fed in early 2007 ultimately gave way a sense of urgency as the storm clouds associated with the subprime mortgage crisis and the financial panic of 2008 appeared on the horizon.

This article examines the official transcripts of the FOMC meetings held throughout 2007 and 2008 to shed light on the Fed’s understanding of, and their reaction to, what would soon become the gravest financial crisis since the Great Depression.  Understanding the Fed’s ability to anticipate a crisis, as well as their policy reactions to an uncertain but potentially severe chain of events, is important in understanding both the abilities and the limitations of a central bank.  While the Minutes of each FOMC meeting are made public three weeks after each meeting, the official transcripts are not released until five years later.  It is these verbatim transcripts that provide key insights into the full range of opinion on the FOMC, the perceived gravity of the situation, and the policy options considered.

At its first few meetings in 2007, the FOMC believed the economy would continue to grow at a “moderate pace” and that inflation pressure would diminish over time.   There was a consensus that the decline in the housing market which started in 2006 had “leveled out” and that housing was likely to improve.  It was not until the Conference Calls on August 10 and August 17 that the alarm bells rang and the Fed began to enact special measures to provide liquidity to the financial markets.  It was not until September of 2008 that the Fed understood the full implications of the events unfolding.

Ultimately, as the dimensions of the crisis became apparent, the Federal Reserve demonstrated an ability to act forcefully to stabilize the financial system.  Nonetheless, the transcripts of the FOMC meetings reveal a central bank that was slow to understand the unfolding crisis.  This inability to anticipate the financial market paralysis just around the corner raises questions about a central bank’s ability to correctly assess “systemic risk,” and, furthermore, its likely success in enacting beneficial “macro-prudential” policies.  This article hopes to inform future monetary and regulatory policies by identifying and evaluating the lessons learned from the 2007-2008 financial crises.