Fed Provided a 'Backstop For the Entire Market'

Updated from 12:27 p.m. to reflect Kevin Warsh's age was 35, not 25 at the time, and additional comments from Chairman Bernanke.

NEW YORK (TheStreet) -- When the financial crisis was seemingly getting worse by the day, the Federal Reserve knew it had to act, but some were concerned about future implications. In Jan. 2008, it didn't truly understand how bad the situation would be become.

The Federal Reserve released the transcripts from its 2008 meetings, including the unscheduled meetings which took place, as the financial crisis worsened. The Fed normally releases these transcripts on a five-year lag, showing the breadth and scope of the conversations that took place during the meeting, which sets monetary policy.

In the Jan. 21 unscheduled meeting, Federal Reserve Chairman Ben Bernanke and his colleagues at the Federal Open Market Committee (FOMC) took action to cut the interest rate by 75 basis points to 3.5%, noting that action had to be taken, and that waiting for the regularly scheduled meeting on Jan. 30, would be damaging in ways the FOMC could not begin to imagine.

Following the run-down of what had gone on in the previous few days by New York Federal Reserve President Bill Dudley, Bernanke knew he had to act, even if it meant bailing out stock investors. "Obviously, it is not our job to target stock values or to protect stock investors, but I think that this is a symptom of both sharply mounting concerns about the economy and increasing problems in credit markets," Bernanke said in the transcript.

What surprised the FOMC was the scope of the unfolding recession, noting that "financial markets reflect US is in for a deep and protracted recession," but that the consequences would have global implications. "Consequently, we saw, for example, an 8 percent drop today in the German stock market. The dollar rose today, reflecting I think increasing belief that other central banks will have to follow us in cutting rates, and oil prices are down to about $87, reflecting expectations of slowing global demand. So it is not necessarily a U.S.-only story."

Bernanke cited the paper by Carmen Reinhart and Ken Rogoff, which had been circulating in the days prior to the meeting, that compared certain indicators of the U.S. economy with other major financial crises, noting "that we [U.S.] rank at the moment among the five largest financial crises in any industrial country since World War II."

One surprising note was that Governor Frederic Mishkin did not attend the event, with Bernanke saying that although he was aware of the meeting, he was "on the slopes - I think in Idaho somewhere."

Bernanke went on to say Mishkin wanted to be aggressive to try and address the problems in the global economy, but then remove accommodation as the situation calmed down. Six years after this meeting, the FOMC is buying $65 billion worth of mortgage backed securities and U.S. Treasuries every month, with a fed funds rate at 0 to 0.25%, indicating that the accommodation has only increased, and the situation has not calmed down.

At the Sept. 16, 2008 meeting, the Fed introduced swap lines with the various central banks around the world, with Dudley recommending it be "pretty broad." This included all the major central banks, such as "the Bank of England, Switzerland, the ECB, the Bank of Japan, potentially Canada." Dudley wanted this to be open-ended, so that markets would not test the limits. "I would suggest that open ended is better because then you really do provide a backstop for the entire market."

Going back to the Jan. 21 meeting, and turning attention to the other Federal Reserve Presidents, those with hawkish views, including Jeffrey Lacker, Bill Poole, and Richard Fisher appear timid in their assesment of the economy, questioning whether the Jan. 21 unscheduled meeting was the right time to act. "Like President Poole, I have real reservations about moving now rather than waiting until our meeting," Lacker said in the transcripts. "I think that in the situation this is inevitably going to be viewed as a reaction to the falloff in equity markets."

The following is a block quote from Lacker, following the talk about waiting for the Jan. 30 scheduled meeting:

"I share President Poole's concern that what we gain isn't clear. I can appreciate the possibility of financial market fragility, but I don't see the level of the funds rate as real closely tied to conditions of fragility. I don't think a funds rate change is going to save the monolines. I don't think it is going to save financial institutions from the monolines. So I have reservations and would rather wait until our meeting. But I can support moving 75."

President Fisher noted that were some pros and cons to moving ahead of the meeting, but cited his concern about having negative real interest rates. "My biggest concern, however, is that I have yet to see convincing evidence that we are seeing movement on the inflation front. If we were to cut rates to this level today, as of now, in terms of the headline CPI and PCE numbers, we would have a negative real rate of interest, and I don't understand quite fully what the consequence of that would be."

Fisher, who was not a voting member in 2008, went on to say that he didn't hear a widespread expectation of recession from his CEO calls, but noted he was only about 30% of his way through the calls. "Unlike President Rosengren, although I am only about 30 percent of my way through my CEO calls in preparing for the meeting, I don't hear a widespread expectation of recession," Fisher is quoted as saying. "I do hear a concern about slowing down, and we have seen that in all of the indexes that I like to talk about in the meetings from the credit card payables, delinquencies in payments, the Baltic index, et cetera, et cetera. But the words 'severe recession' I have yet to hear from the lips of anybody but those in the housing business, and for them, it gets more severe with each passing moment. So I am not convinced of the economic case, and yet I can see where there are some benefits to moving now."

Bill Poole, who attracted the ire of TheStreet's Jim Cramer in his famous "they know nothing" rant, comes off poorly in the transcript. He noted that the rate cut would be seen as reacting to foreign markets, and that cutting the funds rate would do nothing for building up the capital levels for monoline insurers. "I still come back to the point that I do not see a convincing argument for acting today rather than nine days from now, and I see lots of downside to acting today because of the problems that it is going to create for us in the future," he said. "I really believe that, and I just don't see the argument for acting today."

Fed Governor Kevin Warsh, who was the youngest appointment in the history of the Federal Reserve at age 35 in 2006, noted the enormous severity of not acting on Jan. 21, believing the economy was not just fragile, but far, far worse.

The following is a block quote from Warsh from page 23 of the transcript:

"First, during the discussions on this call, we have described these financial markets as fragile. That strikes me as rather euphemistic for what we have been witnessing really since the first of this year, particularly what is being witnessed overseas today. The losses appear to be self-reinforcing. Panic appears to be begetting further pullbacks by investors, retail and institutional alike. There seems to be continued interest in the safest currencies, and this pullback strikes me as quite non discriminate, geographically and in terms of sectors, companies, and even entire asset classes. Certainly, we shouldn't be responding to those moves unless, when we think about our credibility, we think about it both with respect to our inflation-fighting credibility and, I think as Governor Kohn just said, our financial stability credibility. I think the standard for moving between meetings is a very high one; but looking at the evidence, both in the financial January markets and in the real economy, and thinking about our own credibility, my sense is that we rather convincingly meet that standard. My judgment would be, if we chose not to act today, that we would in all likelihood not make it until next week."

Bernanke concluded his final thoughts, saying that the Fed had to learn from the lessons of 2001, and that the Fed was "seriously behind the curve in terms of economic growth
and the financial situation," noting that the Fed was at least "100 basis points behind the curve in terms of neutrality..."

He seemed to dismiss Fisher's concerns about inflation, noting it "is a lagging indicator." The Fed needed to look at the future, with Bernanke mentioning oil being down $10 already, inflation would not be an issue. "We just have to make a judgment," he stated. "With the economy slowing and with oil prices likely to moderate, the best guess is that inflation will be well controlled going forward. If that is not the case, we can begin to address it. But I do believe that, from a forecast viewpoint, we don't have a negative real interest rate, and we don't necessarily have inflation above 4 percent."

Chairman Bernanke noted that the problem of 2001, when Alan Greenspan was Chairman of the Federal Reserve, was not the response itself, but that it was too slow, and things needed to move quicker. "Nevertheless, at the end of that episode, inflation was too low, which is evidence I think that in some sense the response was even inefficiently slow. Not that they could have necessarily done better, but clearly it was not the cut itself that led to inflation problems."

He ended his closing speech, saying that something needed to be done, and to act aggressive. "Let me just add that I do intend to be talking more about the outlook and about policy. I am sure that I will do my best to communicate where I think we are and how we are going to manage policy going forward. I have talked specifically about the need to be aggressive in the short run, particularly when financial stability is at stake. So again, my fundamental point is that we are behind the curve. We need to do something to get up there."

--Written by Chris Ciaccia in New York

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