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.