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Monday August 31st, 2015 6:54AM

Fed underestimated economic crisis in 2007

By The Associated Press
WASHINGTON (AP) -- Federal Reserve officials in 2007 badly underestimated the scope of the approaching financial crisis and how it would tip the U.S. economy into the deepest recession since the Great Depression, transcripts of the Fed's policy meetings that year show.

The meetings occurred as the country was on the brink of its worst financial crisis since the 1930s. As the year went on, Fed officials shifted their focus away from the risk of inflation as they slowly began to recognize the severity of the crisis.

Beginning in September 2007, the Fed cut interest rates and took extraordinary steps to try to ease credit and shore up confidence in the banking system. Throughout the year, the housing crisis deepened. Home prices weakened. Subprime mortgages soured.

As foreclosures rose, banks and hedge funds that had invested big in subprime mortgages were weighed down by worthless assets. Many had trouble getting credit to meet their expenses. The damage reached the top echelons of Wall Street. Fears rose that the U.S. banking system could topple.

At the Fed's Oct. 30 policy meeting, Janet Yellen, then president of the Federal Reserve Bank of San Francisco, noted that the economy faced increased risks. But she didn't foresee anything dire.

"I think the most likely outcome is that the economy will move forward toward a soft landing," Yellen said then.

Yellen was hardly alone in feeling hopeful about the economy in October. At the same meeting, Chairman Ben Bernanke noted that housing was "very weak" and manufacturing was slowing but sounded an optimistic note.

"Except for those sectors, there is a good bit of momentum in the economy," Bernanke said.

Earlier that October, the Dow Jones industrial average closed at an all-time high of 14,164 - nearly 4 percent above where the Dow stands now.

At the October meeting, Timothy Geithner, then president of the Federal Reserve Bank of New York and now Treasury secretary, said: "Developments of financial markets on balance since the last meeting have been reassuring. The panic has receded."

By December, the economy had plunged into the recession, which would officially last until June 2009. Five years later, the economy has yet to fully recover.

The Fed declined Friday to comment on the discussions revealed by the transcripts.

In many places, the transcripts illustrate what has long been known: That the Fed, like most other regulators and economists, was slow to grasp the magnitude of the housing meltdown, the financial crisis and the depth of the economy's weaknesses.

Many analysts, including the rating agencies that gave the mortgage debt high ratings, also badly miscalculated the impact of the mortgage crisis.

Economic growth had slowed sharply in the first quarter of 2007 to below a 1 percent annual rate. And in July and August, employers cut jobs for the first time in four years.

The Fed declined to cut interest rate cuts at its Aug. 7 policy meeting. After that meeting, the Fed issued a statement declaring that the threats to growth had only "increased somewhat." The transcript from that meeting shows that several Fed officials felt that the biggest threat facing the economy was not economic weakness but inflation, which remained mild throughout 2007 and has so since.

A few days after that meeting, BNP Paribas, France's largest bank, announced that it was freezing three funds that had invested in the troubled U.S. mortgage market. That move escalated fears in global markets.

On Aug. 10, the Fed held the first of three emergency conference calls to discuss the emerging crisis. That day, its policy committee took the aggressive step that day of announcing it would pump $19 billion into financial markets. The money was intended to calm turmoil on Wall Street and loosen credit.

A week later, the Fed held an emergency meeting to cut its "discount rate" - the rate it charges on emergency loans to banks. Then in September, the Fed cut its key short-term interest rate for the first time since 2003 by one-half percentage point from 5.25 percent to 4.75 percent. The goal was to help ease loan rates throughout the economy. The Fed would cut the rate two more times in 2007 as the financial crisis worsened, leaving its target for short-term interest at 4.25 percent at the end of the year.

By the October meeting, Fed members expressed some relief that the crisis appeared to be contained, at least for the time being. Fed officials cited more stability in financial markets and solid growth in the July-September quarter for this belief.

Bernanke did acknowledge that there was "an unusual amount of uncertainty" surrounding the Fed's economic forecasts. But in summing up the views of the committee, Bernanke said that in the overall economy, "there is yet no clear sign of a spillover from housing."

At the December meeting, the Fed staff presented its economic forecasts for 2008 and 2009. Growth would slow in 2008, the staff predicted, but the economy would avoid a recession. And growth would rebound in 2009, it forecast.

Even while Bernanke voiced concerns about the lending market and the quality of real estate loans, he predicted at the December meeting that no major bank would fail.

"The result of this is that, although I do not expect insolvency or near insolvency among major financial institutions, they are certainly going to become more cautious."

During the same meeting, Fed economist Dave Stockton, speaking for the staff, said the forecasts sketched a "pretty benign picture" of the economy. He joked that the Fed staff had come up with the projections "unimpaired and on nothing stronger than many late nights of diet Pepsi and vending-machine Twinkies."

As it turned out, Stockton and company were wrong, by a longshot.

Economic growth shrank for five of the next six quarters. The economy lost 8.7 million jobs in 2008 and 2009. The unemployment rate, which was 5 percent in December 2007, spiked during the next two years and hit a post-recession peak of 10 percent in October 2009.

Since then, Bernanke has frequently acknowledged that the recovery proved frustratingly slow. Unemployment remains a high 7.8 percent. Economic growth has been subpar at a roughly 2 percent annual rate for the past three years.

Stockton's forecasts weren't out of line with most private economists at the time.

In March 2008, investment banking giant Bear Stearns needed to be rescued with the help of Fed support. In the fall, mortgage giants Fannie Mae and Freddie Mac were taken over by the government.

In September 2008, the collapse of Lehman Brothers set off a full-blown financial panic.
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