The release of the 2008 FOMC transcripts has once again focused attention on the role the Fed may have played in spawning the Great Recession. The first sign of a crack in the U.S. economy was in April 2006 when the housing sector began to contract. As seen below, it was not until two years later that the entire U.S. economy began to sharply nosedive. So what initially appeared to be an ordinary recession morphed into the Great Recession during the second half of 2008.
So what went wrong in 2008? Was the Great Recession inevitable? Robert Hetzel has an entire book arguing the answer is no. He blames the Fed for falling asleep at the wheel in 2008. So do Market Monetarists. The 2008 FOMC transcripts seem to confirm this view. They show an FOMC so concerned about rising inflation that it decided to abstain from any policy rate changes during the August and September FOMC meetings. But by doing nothing with its target interest rate, the FOMC was doing something: it was signaling the Fed would not respond to the weakening economic outlook. The FOMC, in other words, signaled it would allow a passive tightening of monetary policy in the second half of 2008.
A passive tightening of monetary policy occurs whenever the Fed allows total current dollar spending to fall, either through an endogenous fall in the money supply or through an unchecked decrease in money velocity. The decline in the money supply and velocity are the result of firms and households responding to a bleaker economic outlook. The Fed, therefore, should respond to and offset such expectation-driven developments by properly adjusting the expected path of monetary policy. These two papers show the Fed effectively did this during the Great Moderation period. The FOMC failed to do this in the second half of 2008 and, according to the FOMC transcripts, it was because of inflation fears.
The figures below document this failure by the FOMC. The first figure shows the 5-year "breakeven" or expected inflation rate. This is the difference between the 5-year nominal treasury yield and the 5-year TIPs yield and is supposed to reflect treasury market's forecast for the average annual inflation rate over the next five years. The figure shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. That is a decline of 1.23 percent over the two and a half months leading up to the September FOMC meeting. This forward-looking measure was screaming trouble ahead, but the FOMC ignored it.
One way to interpret this figure is that the Treasury market was expecting weaker aggregate demand growth in the future and consequently lower inflation. Even if part of this decline was driven by a heightened liquidity premium the implication is the same: it indicates an increased demand for highly liquid and safe assets, which, in turn, implies less aggregate nominal spending. Either way, the spread was blaring red alert, red alert!
Now the FOMC allowed these declining expectations to form by failing to signal an offsetting change in the expected path of monetary policy in its August and September FOMC meetings. The next figure shows where these two meetings chronologically fell during this sharp expectation decline.
As noted above, this passive tightening in monetary policy implies there would be a decline in the money supply and money velocity occurring during this time. The Macroeconomic Advisers' monthly nominal GDP data indicates this is the case:
The Fed could have cut its policy rate in both meetings and signaled it was committed to a cycle of easing. It did not and that seems to be what turned an ordinary recession into something far worse. Note that this passive tightening of monetary policy preceded the worst phase of the financial meltdown. So yes, Robert Hetzel, Matthew Yglesias, Matthew O'Brien, Ramesh Ponnuru, James Pethokoukis, Scott Sumner, and Marcus Nunes are correct to claim that by doing nothing the Fed spawned the Great Recession.