* Some grim predictions on fallout from Lehman bankruptcy
* Difficulties gauging economic impact in heat of moment
* U.S. central bank releases transcripts of meetings
By Jonathan Spicer and Ann Saphir
Feb 21 Federal Reserve policymakers, in a tense
meeting on one of the darkest days of the financial crisis,
worried Lehman Brothers' failure would wreak havoc on a
teetering financial system but feared cutting interest rates
might prove an over-reaction.
At a meeting the day after the investment bank filed for
bankruptcy, Fed Chairman Ben Bernanke flatly told colleagues he
was philosophically torn about how the U.S. central bank should
respond, if at all, to the turmoil set off by Lehman's collapse.
The revelation came in transcripts of the Fed's 2008 policy
deliberations released on Friday. The 1,865 pages throw light on
a debate over whether to loosen monetary policy to battle a
crisis that was fast engulfing global financial markets.
In a year that saw the United States and most of the
developed world sink deep into a brutal recession whose scars
still linger, U.S. central bankers wrestled with how to respond
to panicked markets and economic data that sent mixed signals.
At the time, some officials thought the maelstrom would be
resolved quickly, and many were wringing their hands over a
run-up in inflation and hesitant to come to the aid of the
At the Sept. 16 meeting, Bernanke struggled to weigh the
moral hazard of "ad hoc" decisions to help failing banks against
the possibility of "very severe consequences for the financial
system and, therefore, for the economy of not taking action."
"Frankly, I am decidedly confused and very muddled about
this," he said. "I think it is very difficult to make strong,
bright lines given that we don't have a structure that has been
well communicated and well established for how to deal with
In the end, the Fed stood pat. Within a month, however, it
had entered full crisis-fighting mode, and by the end of the
year it had cut rates to near zero and launched the first of its
several controversial bond-buying programs.
On Sept. 16, the day the Fed Board authorized a $85 billion
loan to prevent the bankruptcy of insurer American International
Group, policymakers were torn: inflation was running high, but
signs of economic weakness were everywhere.
People in the tony suburbs across the bay from San Francisco
were even deferring cosmetic surgery, joked then San Francisco
Fed chief Janet Yellen, who succeeded Bernanke at the Fed's helm
earlier this month.
Most of all, officials felt largely unable to gauge the
likely fallout so soon after Lehman's bankruptcy, which turned
out to be the beginning of a market sell-off that would cut the
value of U.S. stocks almost in half.
Boston Fed President Eric Rosengren was one of the few who
seemed certain of the fallout.
"This is already a historic week, and the week has just
begun," he said, predicting firms would dump risky assets "with
He was the only official to call for a rate cut; others
wanted to wait and see.
"Money doesn't talk; it swears," the Dallas Fed's Richard
Fisher said, quoting Bob Dylan. "When you swear, you get
emotional. If you blaspheme, you lose control. I think the main
thing we must do in this policy decision today is not to lose
control, to show a steady hand."
Bernanke, likewise, cautioned against rash action.
"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," Bernanke told the group as he summed up the discussion.
"So it is a step we should take only if we are very
confident that is the direction in which we want to go."
LETTING LEHMAN FAIL
As the worst recession in decades deepened, the U.S. economy
shrank at an 8.3 percent rate in the fourth quarter of 2008. The
unemployment rate soared to 10 percent the following year.
While the recovery has been erratic, growth has been strong
enough and the jobless rate has fallen enough to prompt the Fed
to start to unwind its extraordinary stimulus.
But in 2008, the crisis in the U.S. subprime mortgage market
and in over-leveraged Wall Street banks quickly cascaded around
the world, sparking investor panic.
On Sept. 16, tension was thick as the debate over the course
of monetary policy turned to the issue of whether the Fed and
the U.S. Treasury were right to let Lehman fail.
"I'm seriously interested in knowing what you ... think is
the appropriate stage, if any, at which fiscal intervention
becomes necessary," Bernanke asked Richmond Fed President
Lacker's response: let failing banks fail and leave it to
the Federal Deposit Insurance Corporation to pick up the pieces.
"We have a legislated program of fiscal intervention -
deposit insurance - and the boundaries around that are very
clear," Lacker said.
Kansas City Fed President Tom Hoenig, who is now vice
chairman of the FDIC, concurred, and argued that easing policy
to cushion the blow would merely compound the problem.
Rosengren, who like Lacker remains a Fed policy maker,
countered that it was too soon to know whether letting Lehman
collapse was the right thing to do.
"Given that the Treasury didn't want to put money in, what
happened was that we had no choice. But we took a calculated bet
... We did what we had to do, but I hope we will find a way to
not get into this position again."
In the end, only two of the five U.S. investment firms,
Goldman Sachs and Morgan Stanley, survived the financial crisis
- and only because of an unpopular taxpayer-funded bailout. The
AIG bailout, which totaled $182 billion, also drew public scorn.
BRIGHT SIDE OF LIFE
Tension was also high in the lead up to JPMorgan's buyout of
investment bank Bear Stearns in March, a deal guaranteed by the
On an unscheduled Jan. 9 conference call, Bernanke began the
meeting by saying he thought rates needed to come down, but it
would be appropriate to wait until a meeting at month's end.
Yellen said she could support a half-point rate cut "in the
near future," but said she preferred to cut rates by a
By the Jan. 21 meeting, Bernanke struck a much more urgent
tone in advocating a rate-cut of three-quarters of a point,
which the Fed carried out. "At this point we are facing
potentially a broad-based crisis," he said. "We have to try to
get it under control."
At a meeting a week later, some policymakers tried to look
at positive signs, but Fed Governor Frederic Mishkin said those
efforts reminded him of the Monty Python film that ends with
characters that are being crucified, singing, "Always Look on
the Bright Side of Life."
After an April interest rate cut of a small quarter-point to
2 percent, things looked less dire.
Indeed, the transcripts show top Fed officials thought their
work was largely done. At a meeting in June, Yellen said she
could see the Fed raising rates before year-end.
The market turmoil that followed the collapse of Lehman
upended those expectations.
"I should say that this comes as a surprise to me," Bernanke
said during an Oct. 7 call to line up support for a half-point
cut. "I very much expected that we could stay at 2 percent for a
long time, and then when the economy began to recover, we could
begin to normalize interest rates."
"Clearly things have gone off in a direction that is quite