WASHINGTON — On the morning after Lehman Brothers filed for bankruptcy in September 2008, most Federal Reserve officials still believed that the American economy was growing, and that it would continue to grow, avoiding a recession.
The officials, gathered at the Fed’s marble headquarters for a meeting that had been scheduled months earlier, voted unanimously not to lower interest rates. They were not convinced the spreading financial crisis would drag down the economy, according to a transcript of the meeting the Federal Reserve released Friday.
But in a pattern that repeated itself throughout the financial crisis, Fed officials soon concluded they would need to do much more. Just minutes after the first meeting, a smaller group of Fed officials was pulled into a meeting where they agreed to prevent the collapse of a previously overlooked company at the very center of the financial system, the insurance giant American International Group.
By the end of 2008, the Fed had reduced short-term interest rates nearly to zero for the first time since the Great Depression, and it had become a primary source of funding for the global financial system, providing hundreds of billions of dollars in loans to American and foreign financial firms.
The 14 transcripts that the Fed published Friday — covering the eight scheduled meetings and six more emergency sessions of its Federal Open Market Committee during 2008 —– provide a fuller picture of the Fed’s efforts during the climax of the largest financial crisis in American history.
The transcripts show that the Fed’s initial response to the crisis was constrained by a lack of understanding about the depth of the problems, and a deeply ingrained bias to worry more about the risk of inflation than the reality of rising unemployment. But it also shows that Fed officials responded decisively once the crisis was upon them, perhaps preventing an even deeper recession.
The Fed in normal times is a powerful but somnolent institution, charged with keeping a steady hand on the rudder of the economy. It moves interest rates up and down to moderate inflation and minimize unemployment. But beginning in 2007 it was forced to take on a far more challenging role as a backstop for the global financial system. And then, because of the depth of the resulting recession, Fed officials also found themselves searching for new ways to revive the economy.
The meeting on Sept. 16 was a turning point, the end of the Fed’s measured efforts to do just enough and the beginning of its headlong rush to do everything possible, including many things it had never tried before.
The transcripts show that officials were uncertain whether the collapse of Lehman Brothers would damage the broader economy. The Fed’s chairman, Ben S. Bernanke, told his colleagues that it was clear that the economy had entered a recession, but he still did not favor cutting rates.
“Cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward,” Mr. Bernanke said. “We should be very certain about that change before we undertake it because I would be concerned, for example, about the implications for the dollar, commodity prices, and the like. So it is a step we should take only if we are very confident that that is the direction in which we want to go.”
Other officials also emphasized that the Fed should focus on stabilizing the financial system, including government-sponsored enterprises, or G.S.E.'s, like Fannie Mae and Freddie Mac, and that they were not yet convinced that the broader economy needed help.
“My sense is that three large uncertainties looming over the economy have now been resolved — the G.S.E.'s and the fates of Lehman and Merrill Lynch,” said James Bullard, president of the Federal Reserve Bank of St. Louis. “Normally, the elimination of key uncertainties is a plus for the economy.”
During the meeting, there were 129 mentions of “inflation.” There were just five of “recession.”
That sense of uncertainty, which had inhibited the Fed since January, would not long endure. In the weeks that followed, the Fed would embrace its role as a lender of last resort, expanding its safety net not just for Wall Street but for foreign financial firms and for makers of cars and food and light bulbs.
And by the end of the year, the Fed would also inaugurate its efforts to revive the economy after the crisis, implementing the two strategies that remain at the core of that campaign more than five years later. In November, it would begin to buy mortgage bonds to revive the housing market. And in December, the Fed would drop its benchmark interest rate almost to zero, where it still rests.
The troubles began early. As the year dawned, Fed officials did not know that the economy already was in recession. But Mr. Bernanke and his closest advisers were feeling nervous. They worried the Fed’s actions at the end of 2007 had been insufficient, and that tumbling stock prices were the beginning of a broader pullback in investment.
At first Mr. Bernanke hoped to move deliberately. He orchestrated a Jan. 9 conference call during which officials agreed that action “might well be necessary.” The next day, Mr. Bernanke delivered the same message in a public speech, then again in Congressional testimony the following week.
But over the three-day Martin Luther King weekend, Mr. Bernanke concluded that the Fed could not wait any longer. He convened a conference call at 6 p.m. Monday and won agreement to cut the Fed’s benchmark interest rate by 0.75 percentage points. It was the largest cut in more than two decades.
Janet L. Yellen, then president of the Federal Reserve Bank of San Francisco, told her colleagues at that meeting that “the risk of a severe recession and credit crisis is unacceptably high.”
Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said this week that the meeting was a critical turning point. “If maybe we were a little slow to recognize what was happening, Martin Luther King weekend in January 2008 was a decisive point in terms of interest rate policy,” Mr. Lockhard said.
But Fed officials soon concluded that cutting rates was not sufficient. Financial firms, particularly in the mortgage business, were beginning to fail because they could not find funding. Investors had lost confidence in their ability to predict which loans would be repaid. Countrywide, the nation’s largest mortgage lender, had sold itself for a pittance to Bank of America. Bear Stearns, one of the largest packagers and sellers of mortgage-backed securities, was teetering toward collapse.
By early March, the Fed had reached a momentous decision. The central bank would seek to replace private investors as a source of funding for Wall Street firms.
On March 7, the Fed offered firms up to $200 billion in funding. Three days later, Mr. Bernanke secured the Fed policy-making committee’s approval to double that amount to $400 billion, telling his colleagues, “We live in a very special time.” Finally, on March 16, the Fed effectively removed any limit on the funding.
It also announced that it would help to finance the rescue of Bear Stearns.
“The Federal Reserve, in close consultation with the Treasury, is working to promote liquid, well-functioning financial markets, which are essential for economic growth,” Mr. Bernanke said at a hastily convened news conference. “These steps will provide financial institutions with greater assurance of access to funds.”
By the end of April, the Fed had also cut short-term rates to 2 percent from 5.25 percent the previous September —– one of the fastest falls in Fed history.
For a time, it seemed that the worst of the crisis was over. Officials predicted that the economy would narrowly avoid recession. They expected annual growth between 0.3 percent and 1.2 percent during 2008, and faster growth in 2009, in part because they thought the Fed had done enough to stabilize the economy.
Indeed, some Fed officials began to fret about the risk of resurgent inflation.
But, in fact, the housing finance system continued to crumble. The government was forced to create a rescue plan for Fannie Mae and Freddie Mac —– which served as the central pillars of the home mortgage system — while swearing all the while that the plan would never need to be used. The spreading strain on other companies increased demand for the Fed’s loans.
All through the summer, the Fed continued to tinker with its safety net, gradually expanding the amount of money it was pumping into the financial system and the list of companies that it was willing to support.
By mid-September, it was clear that it was not enough. The crisis had arrived, as Ernest Hemingway once wrote of bankruptcy, “Gradually. And then suddenly.”