Last updated: January 19, 2013 2:59 am

Fed minutes show slow crisis reaction

US Federal Reserve building©Bloomberg

As Congress bickered, the Federal Reserve, on Constitution Avenue above, followed an ultra-loose monetary policy to keep the economy afloat

Top officials at the US Federal Reserve took months to realise that the 2007 financial crisis would rock the world’s largest economy, according to an embarrassing set of meeting transcripts released on Friday.

The transcripts reveal that some Fed policy makers initially viewed the market turmoil, which erupted in August 2007 on the back of problems in the market for subprime mortgage loans, as good news because markets were pricing in more risk.

The records of the Federal Open Market Committee’s 2007 meetings, which are released with a five-year delay, raise the question of whether the recession would have been less severe if the Fed had reacted faster instead of continuing to forecast steady growth.

On August 7 – two days before the European Central Bank made its offer of unlimited funds to eurozone banks to counter a liquidity shortage – one Fed governor described the subprime crisis as “quite a good thing” because it was forcing people to reassess the quality of financial information.

“The point of the subprime market is just that we now trust the credit-rating agencies less,” said Frederic Mishkin. “Basically what I think is happening in a way is quite a good thing: We were concerned that the markets were a little too optimistic, that there was too much opacity, and that people weren’t worried about it. Now, in fact, they are worried about it, and I think that is fundamentally a healthy situation.”

Contacted on Friday, Mr Mishkin noted that he became one of the strongest supporters of easier Fed policy during the crisis. The question in August 2007, he said, was whether “very aggressive lender of last resort type action could contain the problem”.

Important information – such as the extent of giant insurer AIG’s exposure to derivatives on subprime debt – was unknown at the start of the crisis, and the minutes show the Fed wrestling to understand the scope of the problem as it morphed from subprime housing to a run on parts of the “shadow banking” system such as asset-backed commercial paper.

But while some officials worried about the extent of financial market problems, they did not see much risk of recession and forecast only a modest slowdown in growth.

“My forecast for the most likely outcome for output over the next few years is … growth a little below potential for a few quarters, held down by the housing correction, and the unemployment rate rising a little further,” said vice chairman Donald Kohn in August.

“I agree that this reassessment is a fundamentally healthy but somewhat messy correction to more-sustainable term and risk premiums,” he added. “The most likely outcome is that it will be limited in duration and effect, and that’s what I assume for my forecast.”

The crisis in the market for subprime loans set off a series of events that eventually led to the collapse of US investment banks Bear Stearns and Lehman Brothers. But initially the subprime market seemed far too small to cause a recession. That view was also widely held by private economists at the time.

By December of that year, Fed officials began to recognise the scale of the problem. At the FOMC’s meeting on December 11, Janet Yellen, then president of the San Francisco Fed, said: “The bad news since our last meeting has grown steadier and louder, as strains in financial markets have resurfaced and intensified and as the economy has shown clear signs of faltering ... The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real.”

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