The leaders of the Federal Reserve went around the room saluting Alan Greenspan during his last day as chairman of the central bank. Then Timothy F. Geithner, the future Treasury secretary, made a prediction.
“I’d like the record to show that I think you’re pretty terrific, too,” Geithner, who was president of the Federal Reserve Bank of New York, told Greenspan amid laughter on Jan. 31, 2006. “And thinking in terms of probabilities, I think the risk that we decide in the future that you’re even better than we think is higher than the alternative.”
On Thursday, the Fed released transcripts of its meetings in 2006, offering a new window into what was on the minds of some of the nation’s top economic and financial thinkers just ahead of the financial crisis and subsequent great recession. The transcripts, which are customarily released after five years, show that Fed leaders, armed with the best economic data available, had little idea of what was looming less than two years off.
Trusted to look toward the future and make decisions to keep the economy strong, they spent some of their time patting their leader on the back and even found time to joke about what turned out to be early-warning signs in the markets. While Fed officials — including several who are in key positions today — were aware that the nation’s rapid increase in housing prices was coming to an end, they significantly underestimated how much damage the popping of the real estate bubble would cause in the rest of the economy.
In his first meeting as Fed chairman, in March 2006, Ben S. Bernanke noted the slowdown in the housing market. But he said he shared the view that “strong fundamentals support a relatively soft landing in housing,” adding: “I think we are unlikely to see growth being derailed by the housing market.”
The year began with adulation all around for Greenspan. In that January meeting, Roger Ferguson, then Fed vice chairman and now head of the TIAA-CREF financial services group, called Greenspan a “monetary policy Yoda.”
Janet L. Yellen, then president of the Federal Reserve Bank of San Francisco and now the Fed’s vice chair, told Greenspan “that the situation you’re handing off to your successor is a lot like a tennis racket with a gigantic sweet spot.”
In the six years since, Greenspan’s record — seemingly so sterling when he left the central bank after 18 years — has come under substantial criticism from outside economists and analysts. Many say a range of Fed policies under his watch contributed to the financial crisis, including keeping interest rates low for too long, failing to take action to stem the housing bubble and allowing inadequate oversight of financial firms.
A spokesman for Greenspan did not respond to a request for comment. A spokeswoman for the Fed declined to comment. Treasury Department spokesman Anthony Coley said: “Secretary Geithner was an early source of initiative at the Fed to reduce risk and make the financial system more resilient even before 2006.”
Greenspan has acknowledged in recent years that he was “partially” wrong for allowing banks to operate without enough regulation. Bernanke has defended the Fed’s decisions about interest-rate policy and the overall economy but said that “stronger regulation” would have been “more effective” at constraining the housing bubble.
The 2006 transcripts show that Fed officials — like most economists on the outside — considered tremors in the financial markets as not much to worry about. Some were even a source of humor.
In a March meeting, for instance, a Fed economist gave a presentation that expressed modest concerns about Iceland, a small country whose enormous banks were highly indebted.
“We’d like a full report on the Icelandic,” Bernanke said, before he was interrupted by laughter.
Two years later, Iceland’s banks defaulted on their debts, feeding the financial crisis.
Throughout the year, the Fed was slow to realize what was happening in the housing market and the threats it posed, as borrowers who took on risky subprime loans defaulted, causing foreclosures.
There was at least one Cassandra. Former Fed governor Susan Bies warned that banks had built their models for “falling interest rates and rising housing prices.”
“It is not clear what may happen when either of those trends turns around,” she said.
Bernanke responded later: “So far we are seeing, at worst, an orderly decline in the housing market; but there is still, I think, a lot to be seen as to whether the housing market will decline slowly or more quickly.”
In June 2006, the Fed still wasn’t totally aware of what was happening in the market. A Fed economist reported that “we have not seen — and don’t expect — a broad deterioration in mortgage credit quality.” That turned out to be an incorrect description of what was actually occurring.
By August 2006, there was an increasing awareness that problems in housing could lead to problems in the rest of the economy. Said Yellen: “The housing slowdown could become an unwelcome housing slump.”
Bernanke acknowledged that there might be some “spillover effect” from housing into the rest of the economy.
But others had their attention elsewhere. Geithner was identifying the threat of inflation as the main challenge for the Fed.
At the end of the year, officials were still optimistic.
“The current weakness in the economy still seems principally to stem from the direct effects of the slowdown in housing on construction activity” and other factors, Geithner said in December 2006. “The softer-than-expected recent numbers don’t argue, in our view, for a substantial reassessment of the risks in the outlook.”
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