Chairman Ben and the lost boys (and girls) in Neverland

Each year, when it releases its full transcripts of the Federal Open Market Committee (FOMC) from five years ago, the Fed invites us to cast our minds back to a place long ago and far away. The conversation around the conference table at the Fed's Washington headquarters on January 30 and 31, 2007¹ seemed to take place in Neverland rather than on the verge of the worst financial crisis since the Great Depression.

Housing starts had fallen steeply from almost 2 million (annual rate) in early 2006 to about 1.1 million at year end, just before the FOMC met. The Feds were not worried however (there are few worries in Neverland) because their model predicted that the rate would soon rebound to a normal 1.3 million level. Problem solved! (But in fact, starts fell to 400 thousand by the end of 2008.) The FOMC did fret pleasantly about inflation, however.

In fact, only a relatively few paragraphs of the 200+-page transcript were devoted to the housing crisis. Here is a sampling. Moskow of the Chicago Fed said that that “the economy is clearly showing more underlying strength than we thought in December.” Lacker of Richmond commented that “each batch of housing data has bolstered my confidence in the trajectory we sketched out last fall – namely, that a drag from housing will mostly disappear by midyear with spillover having been relatively limited.” Gov. Bies said, “we feel very good about overall credit quality.” Gov. Mishkin commented, “we're not seeing anything out of the ordinary or a persistent pattern, and that gives me more confidence that nothing bad is going to happen here.” (Mishkin had co-authored a study proving that nothing bad could happen in Iceland either.) Bernanke summarized: “The general view was that housing would cease to subtract from growth later this year.” Yellen of San Francisco agreed: “Housing remains a concern, but I think the prospects for a really serious housing collapse that spreads to consumer spending have diminished substantially. . . To me the upside risk to inflation seems palpable, especially because labor markets have tightened.” (Yellen is the reputed front-runner to succeed Bernanke, assuring a continuation of .. . ah . . continuity; the magical Veil of Nescience that Dr. Greenspan bequeathed to Chairman Bernanke seems to sit well on her brow.)

The Fed GDP forecast at the meeting was a cheery 2.2% rate in the first half of 2007, 2.4% in the second, and 2.5% for 2008, not the 2% for 2007, 0% in 2008, and -4% in 2009 that actually befell the world outside of Neverland. Back on planet earth alarm bells were ringing non-stop.² Barrons had suggested in August 2006 that housing prices could drop 30%. At the Davos conference just before the Fed meeting, Nouriel Rubini made dire predictions, and the Bank for International Settlements warned of a deepening crisis. Despite these warnings, the Fed stuck to its rosy scenario because in Neverland every time someone says “I don't believe in fairies” a fairy dies.

Even Euromoney seems to have got it right! In the January 2007 cover story, “The world on the cusp,” which was well-illustrated by a drawing of a world on a cusp, Clive Harwood introduced a series of articles that presented “the view that the state of global imbalance must come to an end soon, and with painful consequences.” Charles Dumas predicted “a hard landing followed by poor recovery,” that would “likely cause severe deflation.” Brian Reading followed by stating that “the world is suffering unprecedented financial imbalances” and that “their inevitable reduction . . . will dominate global growth prospects. . .”

But even in Neverland where all stories have happy endings, drama exists. Think of Hook and the crocodile. At the Fed meeting, drama came in the form of the interim president of the Atlanta Fed, Mr. Pat Barron, a practical, energetic, and brilliant man who rose from auto mechanic at Buckhead Chrysler Plymouth to COO of the Atlanta Fed. He is a practitioner not of mathematical economics, like Dr. Ben, but of “descriptive economics,” which is now derided in academe and defined as explaining “economic phenomena as they are without making any statements about how they ought to be.” He expressed a “contrarian view” that the housing market was in deepening crisis. The Lost Boys (and Girls) listened politely to this real world Wendy and moved on.³

History suggests that investors should assign a correlation of -1 to the forecasts of certain central bankers. Ben says the exit from QE will be orderly. Where is he leading us? “Second star to the right and straight on till morning.” That's where you'll find Neverland.

1http://www.federalreserve.gov/monetarypolicy/fomchistorical2007.htm

2See Tee,Gillian, Fool's Gold, Free Press, New York, 2009, especially chapter 10: “Tremors.”

3 According to Tett's book, Geithner was also worried, but ever the good subordinate, he kept his peace.