December 2007, Part 1: Yellen was right

I finally got around to reading the transcripts for the Fed meeting of December 2007.  There’s no point in reading earlier 2007 transcripts–the December meeting was the important one.  Indeed it was one of the two key turning points, the other occurring in the fall of 2008.  December was a key meeting for several reasons:

1.  The Fed was split over whether to cut rates by a quarter or a half point.  It opted for a 1/4% cut.  The market response was very unusual.

2.  The recession began in December.

When the Fed adopts a tighter than usual policy, it will usually either raise short term interest rates, although long term rates may fall.  If it’s a one time contractionary shock, which doesn’t impact the expected rate of NGDP growth, it will often raise interest rates.  Sometimes it will raise short term rates and reduce long term rates.  But the December 2007 decision to raise lower rates by less than the markets expected actually reduced rates from maturities of 3 months to 30 years. That’s extremely unusual.  What caused this unusual market response?

The most likely explanation is that the bond market saw something the Fed didn’t see, an economy teetering on the edge of recession.  The more contractionary than hoped for Fed decision was the last straw, causing the bond market to expect a mild recession, and hence triggering expectations that the Fed would have to sharply cuts rates in the near future—as it realized it had erred.

So by cutting rates less than the bond market had hoped for, the Fed actually caused rates to fall, on expectations of much slower NGDP growth.

The Fed move also triggered a sharp plunge in equity prices right after the 2:15 announcement.  Fed funds futures markets showed a 58% likelihood to a 25 basis point cut and a 42% likelihood of a 50 basis point cut.  Thus about 700-800 points on the Dow swung on a mere 25 basis points.  Why so much?  Surely a quarter point at one meeting can’t make that much difference?  I’ll answer that question in the next post.

At the Fed meeting of December 11, 2007, there were only 2 serious options.  Four participants spoke out in favor of a 50 basis point cut (Rosengren, Yellen, Lockhart, Mishkin), while 12 favored a half quarter point cut.  Many in the majority thought it was a very tough call, so the markets were right that it could have gone either way.  Just three months earlier stock prices had soared on a bigger than expected 50 basis point cut.

Here’s Janet Yellen:

Market perceptions of future real interest rates are also very low, with yields on five-year Treasury inflation-indexed bonds now below 11⁄4 percent. I think the headwinds from financial market turmoil and the more general reassessment of risks that is taking place in global markets are good reasons why the equilibrium real rate may be low in the current situation. . . .

With an assumed 25 basis point cut at this meeting, the Greenbook foresees the economy barely skirting a recession, so any more bad news could put us over the edge; and the possibility of getting bad news—in particular, a significant credit crunch—seems far from remote. To my mind, the risk to the forecast and the risk of a vicious cycle, in which deteriorating financial conditions and a weakening economy and house prices feed on each other, argue for adopting a risk-management strategy that, at the very minimum, moves our policy stance to the low end of neutral—namely, a cut of 50 basis points—and I think it argues for doing so now rather than taking a “wait and see” approach and lowering it only grudgingly. This may not be enough to avoid a recession—we may soon need outright accommodation—but it would at least help cushion the blow and lessen the risk of a prolonged downturn. . . .

If the Committee goes with the 25 basis point cut, then I would support using the assessment of risks from section 4, alternative C, which states clearly that the predominant concern is the downside risk to growth. Otherwise I fear that market participants may mark up their expected path for policy over the next year, leading to further erosion in financial conditions. Finally, I would suggest that, given the long period of time between today and the next FOMC meeting, we be open to the possibility of a special intermeeting videoconference to assess economic and financial developments, and this meeting could also benefit from an assessment of the effects of the TAF once it’s in place.

She was completely correct.  I was especially interested in her “teleconference” comment.  The decision to cut rates by only 25 basis points was so destructive of market confidence that financial conditions almost immediately deteriorated sharply.  Bernanke was not able to wait until the next scheduled meeting (in late January.)  Instead they had an emergency videoconference meeting where rates were cut a whopping 75 basis points, and then another 50 basis points a few days later at the regular January meeting.  So the fall in 3 month bond yields on the contractionary policy surprise, which seemed irrational at the time, was actually remarkably prescient.

It was a missed opportunity by the Fed, but initially the recession was extremely mild.  In the next post I’ll explain why the stock market reaction was so negative.


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17 Responses to “December 2007, Part 1: Yellen was right”

  1. Gravatar of dtoh dtoh
    4. February 2013 at 23:44

    Scott,
    I’ll beat you to it. Corporate profits and thus the returns and prices on stocks are much more sensitive than bonds to changes in NGDP. Thus the very large move in stock prices. I also suspect that the realization of Fed incompetence also caused the market to expect a deeper and longer recession than they had previously anticipated.

  2. Gravatar of OneEyedMan OneEyedMan
    5. February 2013 at 04:23

    I think you have a typo. “…while 12 favored a _half_ point cut.”
    should be:
    At the Fed meeting of December 11, 2007, there were only 2 serious options. Four participants spoke out in favor of a 50 basis point cut (Rosengren, Yellen, Lockhart, Mishkin), while 12 favored a _quarter_ point cut.

  3. Gravatar of Saturos Saturos
    5. February 2013 at 05:16

    Off topic: Joseph Gagnon calls for capital controls:
    http://www.bloomberg.com/news/2013-02-04/imf-shows-u-s-how-to-restrict-foreign-capital.html

    And I was beginning to like the guy.

  4. Gravatar of marcus nunes marcus nunes
    5. February 2013 at 06:12

    Scott
    Yellen was right and so was Mishkin (up to a point). But in his summary of the meeting Bernanke was awful:
    “If the choice were between 0 and 50 basis points, I would be very tempted to do 50 basis points. I think it would move us more toward accommodation, and it would be very pleasant to get the same kind of market response we got after September in terms of improved functioning and credit extension. That said, I think there are some risks to going with 50 basis points. I acknowledge what others have said, which is that it is not just about the rate but also about what the message is. In particular the markets already expect us to ease quite a bit more. We are not pushing strongly back against it with 25 basis points. If we do 50, we may be saying to the market that we are willing to do even more than you currently expect. I think that poses some risks to inflation expectations and poses some risks to the dollar, which is a little fragile right now.”

    http://thefaintofheart.wordpress.com/2013/01/18/the-2007-fomc-transcripts-are-out/

  5. Gravatar of ssumner ssumner
    5. February 2013 at 07:22

    dtoh, That’s basically it.

    OneEyedMan–actually I had two typos–both are now corrected.

    Saturos, I have very different views on international macro than Gagnon–he also worried about the Chinese surplus.

    Marcus, I have Mishkin and Bernanke posts coming up.

  6. Gravatar of When the Federal Reserve Got It Wrong When the Federal Reserve Got It Wrong
    5. February 2013 at 08:00

    [...] 5, 2013 Categories: Economy, Financial Markets Scott Sumner looks back at the recently released transcripts from the Federal Open Market Committee meeting in [...]

  7. Gravatar of Adam Adam
    5. February 2013 at 10:08

    Here’s the weird thing: private equity activity had already come to a screeching halt as a result of the credit contraction.

    I could see that from my perch as a lawyer working in a related field. I would have thought that those more responsible for monitoring things overall would have noticed too.

    The credit crunch alone should have been a reason to be very concerned.

  8. Gravatar of Doug M Doug M
    5. February 2013 at 10:12

    Why does so much swing on a quarter of a point. Not only was there the quarter point that wasn’t cut, but it also creates a signal to the markets to how the fed will be acting in the comming months. A quarter point cut following a half point cut signals that the Fed thinks it is done or nearly done cutting. A half point cut suggests that the Fed cut again in six weeks and possibly six weeks after that.

  9. Gravatar of Doug M Doug M
    5. February 2013 at 10:16

    I see that you made my point in the following post.

    I suppose I should read everything before I say anything.

  10. Gravatar of babar babar
    5. February 2013 at 11:59

    IIRC the catalyst for the “emergency” rate cut was the drop in equities caused by the mistake at SocGen (Jerome Kerviel’s fraud). IIRC the markets were going haywire that day and the french authorities didn’t bother notifying the americans.

  11. Gravatar of Geoff Geoff
    5. February 2013 at 13:43

    Dr. Sumner:

    I know you don’t much like to make predictions or talk seriously about “bubbles”, but I am really interested in what your thoughts are about the student loan market.

    Do you think about of any of the possible causes for it? Do you have any thoughts on how this market collapsing (like housing) would affect the greater economy, given that education is such an important industry? If NGDP is on target, would you recommend debt forgiveness or not? Should millions of students declare bankruptcy and forgo sufficient future borrowing capacity? Can the economy grow with on target NGDP but with a dilapidated education industry?

  12. Gravatar of dtoh dtoh
    5. February 2013 at 14:27

    Geoff,
    Get rid of government involvement in student loans. Phase it out over 5 or 10 years. Higher education is a train wreck waiting to happen. Better slow it down now so the crash is not so bad.

    Put in place a universal voucher system for K-12 and selectively extend it on a need/merit basis for higher education.

    Think what a boost to the economy it will be when all those smart academics have to go out and find other productive work.

  13. Gravatar of Geoff Geoff
    5. February 2013 at 16:58

    dtoh:

    Get rid of government involvement in student loans? Well that’s the obvious answer, but what about all the incentives and moral hazard and, yes, a friggin money printing machine that the government can indirectly depend on whilst telling the banks “Don’t worry, lend to as many students as you can, we got your back. We need to compete with those commie bastards in China”?

    That’s a huge hurdle.

  14. Gravatar of Steve Steve
    5. February 2013 at 19:03

    ssumner: “December was a key meeting for several reasons”

    It’s worth pointing out that the bank runs began in November 2007, not September 2008.

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a0cAD8n1_v9M&refer=home

    “E*Trade Shares Fall; Analyst Says Bankruptcy Possible (Update6)

    By Edgar Ortega – November 12, 2007 18:48 EST

    Nov. 12 (Bloomberg) — E*Trade Financial Corp. lost more than half its market value after the online brokerage forecast a decline in fourth-quarter earnings and a Citigroup Inc. analyst said the company may go bankrupt”

    “`Run On The Bank’

    Since the Federal Deposit Insurance Corp. guarantees bank accounts up to $100,000, customers with larger balances may move their money elsewhere, said Bhatia, who cut his rating on the stock to “sell” from “hold.” “There is a real possibility of a run-on-the-bank scenario,” he wrote in the report.”

  15. Gravatar of Steve Steve
    5. February 2013 at 19:07

    We had a hard money, inflation fighting policy for a full year AFTER the bank runs started. It’s truly incredible when I think back on it. But, but, but, the FOMC protests, it’s all contained!

  16. Gravatar of ssumner ssumner
    6. February 2013 at 06:18

    Geoff, I know little about student loans, but it wouldn’t surprise me at all if it was another crisis waiting to happen.

  17. Gravatar of Geoff Geoff
    7. February 2013 at 19:51

    Dr. Sumner:

    “Geoff, I know little about student loans, but it wouldn’t surprise me at all if it was another crisis waiting to happen.”

    I know less than little. There are so many complexities there. I think I am at the “I’m scared” stage.

    Education is so important. If the student loan market goes belly up, and universities around the country, the infrastructure, the dependent businesses and the whole educational establishment suffers a decline, that would have I think extremely disturbing consequences. It would lead to lower quality politicians, policymakers, and Fed board members. Having less and less intelligent people with the most powerful police force and military the world has ever seen, scares the living daylights out of me.

    Maybe you can make a post full of comforting BS just to calm my nerves?

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