The Great Unraveling
Years of Fed Missteps Fueled Disillusion With the Economy and Washington
Once-revered central bank failed to foresee the crisis and has struggled in its aftermath, fostering the rise of populism and distrust of institutions
By Jon Hilsenrath
In the past decade Federal Reserve officials have been flummoxed by a housing bubble that cratered the financial system, a long stretch of slow growth they failed to foresee and inflation persistently undershooting their goal. In response they engineered unpopular financial rescues, launched start-and-stop bond buying and delayed planned interest-rate boosts.
“There are a lot of things that we thought we knew that haven’t turned out quite as we expected,” said Eric Rosengren, president of the Federal Reserve Bank of Boston. “The economy and financial markets are not as stable as we previously assumed.”
In the 1990s, a period known in economics as the “Great Moderation,” it seemed the Fed could do no wrong. Policy makers and voters saw it as a machine, with buttons officials could push to heat or cool the economy as needed. Now, after more than a decade of economic disappointment, the central bank confronts hardened public skepticism and growing self-doubt about its own understanding of how the U.S. economy works.
For anyone seeking to explain one of the most unpredictable political seasons in modern history, with the rise of Donald Trump and Bernie Sanders, a prime suspect is public dismay in institutions guiding the economy and government. The Fed in particular is a case study in how the conventional wisdom of the late 1990s on a wide range of economic issues, including trade, technology and central banking, has since slowly unraveled.
Once admired globally for their command of the economic system, central bankers now are blamed by the left and right for bailouts during the financial crisis and for failing to foresee and manage forces suffocating the global economy in its aftermath.
Populist protest movements called “Fed Up,” “End the Fed” and “Occupy Wall Street” lashed out at the bank’s policies, and in the case of End the Fed, its very existence. Lawmakers of both parties want to subject it to more scrutiny or curb its powers.
How Americans rate federal agencies
Share of respondents who said each agency was doing either a ‘good’ or ‘excellent’ job, for the eight agencies for which consistent numbers were available
Source: Gallup telephone polls, most recently 1,020 U.S. adults conducted Nov. 11–12, 2014, with a margin of error of +/-4 percentage points
David Einhorn, founder of the hedge fund Greenlight Capital, cites the fable of the ant and the grasshopper, in which a famished grasshopper begs a thrifty ant for help in wintertime after failing to stockpile food during warmer weather.
“We had the grasshoppers party from 2002 to 2007 and winter came and the Fed bailed them out,” said Mr. Einhorn, referring to financial firms and individuals who lived above their means. “Now the ants are pissed.”
The Fed’s struggles will be on display from Friday to Sunday when it gathers for an annual retreat in Jackson Hole, Wyo. On issues of growth, inflation, interest rates, unemployment and how to fight a recession, basic assumptions inside the central bank’s complex computer models have been upended.
“I certainly myself couldn’t have imagined six, seven years ago that we would be employing the policies we are now,” Fed Chairwoman Janet Yellen said to a packed ballroom in New York earlier this year. She lamented the government has leaned so heavily on the Fed to stimulate the economy while tax and spending policies were stymied by disagreements between Congress and the White House.
Many Fed officials believe—and private economists agree—their responses to the crisis helped avert a second Depression, outweighing any unfairness in the bailout process. Fed leaders believe low rates helped, too. “Inflation would be lower and unemployment higher now by noticeable amounts had we not employed those policies,” Ms. Yellen said in March.
Regardless, confidence in the central bank’s leadership has dropped. An April Gallup poll found 38% of Americans had a great deal or fair amount of confidence in Ms. Yellen, while 35% had little or none. In the early 2000s, confidence in Chairman Alan Greenspan often exceeded 70%.
How confidence in the Fed leader has shifted
How much confidence do you have that the Fed leader will do the right thing for the economy?
Note: Percentages may not total 100 due to rounding. Source: Gallup telephone polls, most recently of 1,015 U.S. adults conducted April 6–10, 2016, with a margin of error of +/-4 percentage points
The Fed’s own uncertainty about the economy’s underpinnings is more than a decade in the making and traces back to three key developments that have thrown officials for a loop.
First, officials missed signs that a more complex financial system had become vulnerable to financial bubbles, and bubbles had become a growing threat in a low-interest-rate world.
Secondly, they were blinded to a long-running slowdown in the growth of worker productivity, or output per hour of labor, which has limited how fast the economy could grow since 2004.
Thirdly, inflation hasn’t responded to the ups and downs of the job market in the way the Fed expected.
The shifting financial, productivity and inflation scenarios made it hard to gauge where interest rates belonged even before the financial crisis and are central to Ms. Yellen’s dilemmas today.
She is trying to raise short-term rates, but the economy so far has proved too feeble to absorb more than one small increase from near zero last December. If she waits too long before moving again, she could encourage bubbles. If she raises rates too much, she could cut off a fragile expansion and, in a replay of Japan’s experience, never drive inflation to the Fed’s target of 2%.
“Unfortunately, all economic projections are certain to turn out to be inaccurate in some respects, and possibly significantly so,” Ms. Yellen warned in a June speech. “The uncertainties are sizable.”
How often the Fed’s economic projections missed the mark, and by how much
*Fed estimates reflect the midpoint of central tendency of estimates included in the Fed leader’s twice-annual report to Congress. Central tendency is the range of Federal Open Market Committee participants’ estimates, excluding the three highest and the three lowest. Some periods have more estimates than others, based on how many years into the future the Fed forecast at the time. Estimates have been compared to the most recent reported actual value for each period. The Fed measures both inflation and GDP based on the fourth quarter value’s change from the same quarter a year earlier. Sources: Federal Reserve (forecasts); Commerce Department (actual inflation and GDP)
One window into the Fed’s run of misjudgments is a computer model it uses to calibrate how the economy is likely to respond to changes in interest rates and outside shocks. It is called FRB/US, known as “Ferbus.”
Simulations the Fed did with FRB/US during debates about a possible housing bubble in 2005 and again in 2007 failed to show how a fall in home prices would ripple through the financial sector, freezing credit that was the lifeblood of the economy.
“Assuming that the FRB/US model does a good job of capturing the macroeconomic implications of declining house prices, such an event does not pose a particularly difficult challenge for monetary policy,” John Williams, then a Fed analyst and now president of the San Francisco Fed, said during a debate on the housing boom in 2005.
The model showed the economy could weather a 20% drop in home prices with small increases in unemployment and modest cuts in interest rates.
Ferbus didn’t account for the damage that unstable financial institutions can do to an economy. Unemployment rose to 10%, the Fed cut rates to near zero and then launched programs that ballooned its securities portfolio to more than $4 trillion.
Photo: Jason Henry for The Wall Street Journal
“What was missing to me was the in-depth understanding of how much risk and leverage had grown in the financial system and basically how lacking in resilience the financial system as a whole was to this kind of shock,” Mr. Williams said in a recent interview.
Fed officials say they are alert to the financial system’s risks and have cushioned it by forcing banks to hold more capital. Other entities, such as hedge funds and money-market funds, are more closely watched.
Still, some worry that even with those efforts, continuing very low rates could feed instability by driving investors too heavily into some asset class in search of higher returns.
Mr. Rosengren is worried about booming commercial real estate. “You do have to think about some of the collateral effects that can occur when interest rates are low for a long period,” he said. “Real estate is one of those sectors.”
Richard Fisher, former president of the Dallas Fed, said low interest rates are adding to discontent by forcing consumers to save more to meet their nest-egg needs. The unintended message households get from low rates, he said, is “you’re going to have to save a hell of a lot more before you consume.”
Fed models didn’t pick up on a broader economic slowdown already in train by 2004 because the people running the models also didn’t recognize productivity growth was entering an extended slowdown.
In the long run, an economy can expand only at a rate sustained by the growth of its labor force and the productivity of its workers. During the 1990s, output per hour surged, in part because companies poured money into new technologies and machinery. Many economists assumed the high-tech economy would keep fueling rapid productivity growth, but it didn’t, for reasons economists still don’t fully understand.
In the decade from 1994 to 2003, U.S. output per hour worked rose annually by an average 2.8%. Since then it has grown at 1.3%, including just 0.4% since 2011.
Boston Fed President Eric Rosengren and Fed Chairwoman Janet Yellen in October 2014 in Chelsea, Mass., where Ms. Yellen spoke with residents of the economically hard-hit area. Photo: Dominick Reuter/Reuters
Fed officials, failing to see the persistence of this change, have repeatedly overestimated how fast the economy would grow. The Fed has projected faster growth than the economy delivered in 13 of the past 15 years and is on track to do so again this year.
Private economists, too, have been baffled by these developments. But Fed miscalculations have consequences, contributing to start-and-stop policies since the crisis. Officials ended bond-buying programs, thinking the economy was picking up, then restarted them when it didn’t and inflation drifted lower. Its shifts became a source of uncertainty in financial markets.
A slow-growing economy can’t bear high interest rates, and so the Fed also hasn’t delivered as many rate increases as it said it planned. In June 2015, officials estimated their benchmark short-term rate would exceed 1.5% by the end of this year. It remains below 0.5%.
“They have held out the prospect of tighter money, and that has had a discouraging effect on demand to a greater extent than would have been ideal,” said Lawrence Summers, a Harvard professor and former Treasury Secretary. “They have lost credibility by constantly predicting tightening that, out of prudence, they didn’t deliver.”
For years after the financial crisis, officials attributed slow growth to temporary headwinds, such as banks’ unwillingness to lend. Now they are coming to think the productivity slowdown is the root of the problem, and might not go away.
For James Bullard, president of the St. Louis Fed, uncertainty about the long-run growth and rate outlook led to an about-face.
Fed officials regularly project where they think rates are heading over the longer run. The projection is a signal to the public of how monetary policy is expected to evolve over several years. Unsure about how the economy is behaving and what it means for rates, Mr. Bullard scrapped his forecast altogether.
“We are backing off the idea that we have dogmatic certainty about where the U.S. economy is headed in the medium and longer run,” he said in a paper in June.
Inflation is the third ingredient in the Fed’s self-doubt. For years it has been largely unresponsive to the ups and downs of unemployment, defying the conventional view that inflation rises when unemployment falls, and vice versa. Unemployment surged during the financial crisis, but inflation didn’t fall much, as Fed models suggested it should. And when joblessness fell, inflation didn’t move up much, either.
In offices adjacent to Ms. Yellen, two Fed governors, Lael Brainard and Daniel Tarullo, are lobbying against interest-rate increases because they aren’t convinced by models suggesting inflation will eventually rise.
“Inflation is not at our stated target, not near our stated target, and hasn’t been so in quite some time,” Mr. Tarullo said in a June interview.
Still looming is potentially the biggest reversal of all in the modern conventions of central banking. If another recession hits, it isn’t clear the Fed has the tools available to mend the economy, a subject Ms. Yellen could address in Jackson Hole.
Traditionally the Fed cuts interest rates in a downturn. With its benchmark short-term rate near zero, it can’t be pushed much lower. If recession hits, the Fed will likely resort to unpopular tools used after the financial crisis, including Treasury-bond purchases and more promises to keep short-term rates low far into the future.
“We should be extremely worried,” Mr. Summers said. “We are essentially on a fairly dangerous battlefield with very little ammunition.”