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Each year, when it releases its full transcripts of the Federal Open Market Committee from five years previously, the Federal Reserve 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 2007 seemed to take place in Neverland rather than on the eve 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! In fact, starts fell to 400,000 by the end of 2008. The FOMC did fret pleasantly about inflation, however.
In fact, only a relatively few paragraphs of the 200-plus pages of the transcript were devoted to the housing crisis. Here is a sampling. Michael Moskow of the Chicago Fed said that "the economy is clearly showing more underlying strength than we thought in December". Jeffrey 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". Fed governor Susan Bies said: "We feel very good about overall credit quality."
Fed governor Frederic 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 left the Fed the next year, 2008, for Columbia University and to write a study proving that nothing bad would happen in Iceland either. Fed chairman Ben Bernanke summarized the meeting’s mood: "The general view was that housing would cease to subtract from growth later this year."
Janet Yellen of San Francisco agreed: "Housing remains a concern, but I think the prospects for a really serous 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 continuity; the magical Veil of Nescience that Alan Greenspan bequeathed to chairman Bernanke seems to sit well on her brow.
The Fed GDP forecast at the meeting was a cheery 2.2% growth 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.1 Barrons had suggested in August 2006 that housing prices might 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 Horwood 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 Captain Hook and the crocodile. At the Fed meeting, drama came from the interim president of the Atlanta Fed, Pat Barron, a practical 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.2
History suggests investors should assign a correlation of -1 to the forecasts of certain central bankers. Bernanke says the exit from quantitative easing 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.
1 See Gillian Tett, Fool’s Gold, Free Press, New York, 2009, especially chapter 10: ‘Tremors.’
2 According to Tett’s book, New York Fed president Timothy Geithner was also worried, but ever the good subordinate, he kept his peace.
Lincoln Rathnam, PhD, CFA, is an investment professional based in Singapore and Boston. In a career spanning almost 30 years he has managed equity, debt and venture capital portfolios and was a pioneer investor in emerging markets in the late 1980s