The Fed’s Real Mistake in 2007: Forgetting About Aggregate Demand

Federal Reserve Chairman Ben Bernanke waves goodbye to reporters after a press conference following a Federal Open Market Committee meeting at the Federal Reserve Bank headquarters December 12, 2012 in Washington, DC.

Photo by Chip Somodevilla/Getty Images

Mike Konczal has a great column in Bloomberg View on the 2007 Federal Open Market Committee transcripts, and he argues that the Fed’s real problem was taking the eye off the aggregate demand ball.* My way of putting this has been that the Fed’s really serious mistakes were back in 2005 and earlier (on the regulatory front) and then in 2008-2009 (when they stumbled on the demand front) but that their 2007 conduct was basically appropriate. People say they didn’t foresee the full extent of the financial crisis to come in 2007, but that’s largely because they didn’t foresee the full extent of their own failure.

By late 2007, interest rates were already pretty low. They knew that. And they knew there was downside weakness to the economy. They even had experience from 2001 of an economy brushing with deflation and nearing the zero bound. But as Konczal writes, they didn’t seem to think about any of this:

The failures from the overly narrow focus on the financial sector weren’t limited to fiscal policy. In 2007, the Fed didn’t even consider that it would have to keep the economy afloat by adopting unorthodox monetary policy after interest rates hit zero, and would continue to do so even after stopping the financial meltdown. Nor did the Fed expect that it would need to use unconventional methods to continue easing after hitting the zero-bound, which is perhaps why it was years late in moving to the open-ended quantitative-easing policy adopted last year.

Their idea was that they had to prop up the banking system to prevent a broader economic collapse. But it turns out that a broad economic collapse can also tank your financial system. If people lose their jobs, then house prices fall and mortgages end up in default. But not only was the Fed slow to react with “unconventional” measures once it hit the zero bound, it utterly failed to communicate anything about the likely path of monetary policy as rates got very low.

Under “normal” conditions, one stabilizing element of the Fed is that people think they know how the Fed will respond to future contingencies. We all know that if core inflation gets up to 3 percent for a couple of quarters in a row, the Fed will respond with tighter money. That means nobody expects that to happen. And the expectation that it won’t happen helps prevent it from happening. Everyone’s plans are coordinated around a no-high-inflation scenario. And for a long time, that also operated on the downside. But the Fed didn’t articulate in advance any clear ideas about the zero bound to reassure people. People knew Ben Bernanke had written some old papers about this. But he wasn’t publicly speaking about strategies, and we can see in the transcripts that he wasn’t privately trying to build consensus either. It was a failure of contingency planning that exacerbated the problems when the bad contingency arose.

Correction, Jan. 28, 2013: This article originally misidentified the Federal Open Market Committee as the Federal Reserve Open Market Commission.