August 2007 is often dated as the origin of the financial crisis that, in large part, continues to directly afflict advanced economies. As George Soros (2008) writes, in his book The New Paradigm for Financial Markets: the Credit Crisis of 2008 and What It Means:
The outbreak of the current financial crisis can be officially fixed as August 2007. That was when the central banks had to intervene to provide liquidity to the banking systems.
Data suggest August 2007 is significant also because it is the month the Fed’s publicly stated primary policy concern shifted from inflation to deflation (or at least, severely reduced growth).
An empirical illustration of this thesis can be found in the summary statements from the “FOMC: Transcripts and Other Historical Materials, 2007” (link). These statements are the brief press release summarizing what the Federal Reserve was talking and thinking about as the credit crunch approached (full transcripts of the meetings are available, too). The press releases portray little to no concern until August, and then, following a series of meetings and conference calls between Aug 7 and 16, a swiftly growing sense of danger and downside risk to growth. Here is a quick look at the summary statements released by the Fed in 2007.
The Fed began the year by releasing an optimistic word on housing.
January 31, 2007:
Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.
Following the next meeting, in late March, the Fed produced a slightly less optimistic word on housing:
Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.
Perhaps most importantly, in the face of major downward “adjustment” in housing prices, the Fed was still most worried about inflation:
In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected
The May and June meetings each reproduced this identical statement, again and then again saying the Fed’s biggest fear is potential for inflation.
Then came August. And the appearance of the credit crisis. With no prior warning in any previous statement, the August 7th summary reads, in part:
Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.
Later in the statement is another rehash about the Fed’s “predominant policy concern” being the “risk that inflation will fail to moderate.” Note the existence of this statement on August 7, 2007. Striking. It is the last time we will see that statement.
Because, out of nowhere — that is, out of nowhere if you were a journalist or intellectual or citizen relying on the Fed statements to understand the Fed’s understanding of the condition of the economy — comes the need to aggressively attempt an injection of liquidity into financial markets, the opposite action one would expect if inflation were the primary perceived risk.
Following a conference call three days later (Aug 10), the Fed statement announced:
The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee’s target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.
Less than a week later, on Aug 16th, following another conference call, the Fed officially starts implying that the downside to growth (rather than the onset of inflation) is now the primary policy concern. “Financial market conditions have deteriorated,”
and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.
At the next meeting, in September, the Fed started lowering its target for the Federal Funds rate.
This, as we all know, was just the beginning. In the years that followed, the Fed engaged in aggressive monetary actions intended to support growth, and to ultimately induce inflation. The Fed was successful in stabilizing growth, but has yet to truly succeed in terms of inflation. Now, perhaps the circumstances are ripe for both growth and inflation. With the possible bottoming of the housing market, it is of an increased possibility that inflation and higher growth will return in 2013. If so, the Fed actions of late 2007-present will have set the table.
Whether this inflationary growth translates into an actually thriving labor market, that is another question.