Monday was a holiday in the US – Martin Luther King day. But Ben Bernanke was in the chairman’s office at the Federal Reserve, working through the holiday as he often does.
On his desk his Bloomberg, Reuters and Dow Jones terminals flashed red as selling in global equity markets spread from Asia to Europe. The US markets were closed, but US stock futures were still trading, and they too started to plunge. When US markets reopened on Tuesday it looked as though there would be a bloodbath.
For the chairman it was decision time. Mr Bernanke had already resolved the US central bank needed to make a radical adjustment to monetary policy.
Critics were hammering the Fed for being “behind the curve”. The Fed chief still believed it had made the right decisions in late 2007 but a sudden spate of negative economic and financial data convinced him that it needed to change course. But when?
Mr Bernanke had pre-announced a big shift in policy in a speech on January 10. He hoped it would be possible to hold on until the scheduled Fed meeting on January 30 before making a dramatic interest rate change.
But the slide in world stock markets through January had raised doubts as to whether the Fed could afford to wait.
The Fed chairman contacted his two most senior colleagues, vice-chairman Don Kohn and New York Fed president Tim Geithner, to debate moving forward the rate cut. The top Fed officials knew the cost of being seen to react to market moves. Whatever they said, it would revive the notion of a “Fed put” – a de facto guarantee against a sharp market decline.
But they reasoned that the costs of waiting were higher. A self-feeding market rout could take hold that would damage household wealth, raise the cost of capital for business and risk aggravating negative “feed-back loops” in the economy, with banks in particular pulling back from lending.
At 6pm Mr Bernanke convened the Federal Open Market Committee by videoconference and explained his judgment. There was resistence among the regional Fed presidents – Bill Poole, president of the St Louis Fed formally dissented. But Mr Bernanke carried the day.
At 8.20am on Tuesday the Fed announced it was cutting rates by 75 basis points – the largest single cut since the Fed began basing policy on the Federal Funds rate in 1990 – and promised more to come.
The move helped to arrest the market slide, but opinion among investors was sharply divided. “A 75 basis point cut eight days before the next meeting smacks of a panic,” said Max Bublitz, chief strategist at SCM Advisors. Others were more upbeat. “The Fed did not panic, it took a very bold and risky gamble,” said Macro Annunziata, chief economist at UniCredit Markets.
Mr Bernanke did not learn until a day after the cut that one reason why markets plunged on Monday was that Société Générale was unwinding billions in index futures trades built up by a rogue trader.
For reasons that are unknown to the Fed, the Banque de France, which had known about the SocGen problem since at least Saturday and probably Friday, only briefed the Fed on Wednesday.
Mr Bernanke and his colleagues reasoned that even if they had known this on Monday, they would have acted the same way.
But when the SocGen story went public on Thursday, many in the market concluded that the Fed had been bounced into action by a false signal.
Ed Yardeni, president Yardeni Associates, said the statement following the January 30 meeting should read as follows: “The Fed chairman panicked on Monday . . . He convinced all of us to vote for the rate cut except for cranky old Bill Poole. We now realize that the crash was caused by Société Générale which had to cover a massive long position in stock futures attributable to fraud committed by rogue trader Jérôme Kerviel. So we decided not to cut the Federal Funds rate again this time.” Alan Rushkin, strategist at RBS Greenwich Capital, said: “The episode will further dent Fed credibility.”
Many analysts were horrified at the lack of co-ordination between the Fed, the Banque de France and European Central Bank. “Is the level of communication between central banks as good as it once was?” asked Avinash Persaud, chairman of Intelligence Capital.
However, others were more willing to accept the Fed claim that information about SocGen would not have made any difference.
“The idea that all this was caused by one trader’s mistake is very convenient but there are worse things out there,” said a senior European investment banker.
Richard Berner, chief US economist at Morgan Stanley, said: “There were a number of other market factors that were not related to SocGen and more to the downgrade of the monoline insurers.” He added: “I personally believe the Fed thought they had gotten behind the curve, recognised that and wanted to catch up.”
John Taylor, a professor at Stanford, said: “This to me was moving forward something that was going to happen anyway. The idea of doing it in the middle of very difficult market times seems to me was a good thing.”
However, Alan Blinder, a professor at Princeton, said that while the substance of the Fed move was right, it was paying the price for not having moved on January 10 when Mr Bernanke gave his big speech.
“The unfortunate thing was the timing,” he said. Because the Fed tried to wait, then reacted to a market rout, it was exposed when it turned out the causes of the rout were not as the Fed believed.
For their part senior Fed officials insist the SocGen news will have no bearing on their decision on January 30 – when they are widely expected to cut interest rates by 50bp.
Experts inside and outside the Fed say the evolution of the economy will ultimately show whether Mr Bernanke and his colleagues overreacted to market signals – or did what was necessary, possibly even a bit late in the day.
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