Condensed minutes of FOMC (Federal Open Market Committee) meetings are released three weeks after each meeting.  Detailed transcripts for the meetings in a given calendar year are released five years after the end of that calendar year.  Thus, last month the detailed transcripts for the 2006 FOMC meetings were released.  These transcripts have received a lot of interest; in part because market participants want to understand if FOMC members had any clues about the upcoming financial debacle that was to surface in 2007 and continue into 2009.   

The January 2006 meeting was the last one for outgoing Chairman Alan Greenspan and the March meeting was the first for incoming Chairman Ben Bernanke.  Scholars of the Fed are interested in differences in how the meetings were conducted under the different Chairmen.  A partial answer to that question is that the Bernanke Fed is more collegial with greater discussion (and much longer transcripts).  Instead of starting out the policy discussion with his view, as Greenspan tended to do, Chairman Bernanke goes around the room seeking input before revealing his own recommendation.

Policy wise, the key event in 2006 was cessation of the policy tightening in June, after 17 consecutive 25 basis point increases in the target funds rate.  Some members of the committee were reluctant to pause in the tightening, on the grounds that inflation and growth were above comfortable levels.

Regarding the key issue of assessing elevated risk levels and anticipating the upcoming calamity, it does not appear that the Fed had any sense of potential impending disaster, at least not as of December 2006.  Recall that the housing boom extended from the late 1990s into 2005 in terms of huge construction activity, strong sales of homes and double digit housing price appreciation.  Housing activity stalled out in 2005 and was declining sharply in 2006.  Meanwhile, housing price appreciation began slowing in 2005 and was pretty close to zero by the end of 2006.  In retrospect, economists and commentators see a massively overbuilt market and a housing price bubble in many areas (mostly, the ones that have seen huge housing price depreciation since 2006). 

For the most part, this is hindsight bias.  After an event has occurred, the probability of that event is 1.0, even if the ex ante probability was very low.  The transcripts show that the staff and FOMC members were aware of a slowdown in housing and potential risk to the overall economy, but did not believe a hard landing was likely.  It was recognized that speculative activity in housing was slowing, indeed that cancellations of home purchase contracts were as high as 80% in some areas near Phoenix and Las Vegas.  It was further noted (primarily by Governor Susan Bies) that mortgage early payment defaults were rising and investors in mortgage backed securities were nervous.   But even she felt this was a narrow problem mostly applicable to “private label” (i.e., non-agency) securities and for loans originated outside of regulated banks. 

Next January when the 2007 transcripts are released, it will be interesting to see at what point during the year did the Fed perceive that something was fundamentally amiss.  The secondary market for non-agency mortgages died in the first week of August 2007, as did the market for asset backed commercial paper.  There were two unscheduled FOMC meetings in August to discuss the turmoil in money markets, and then the Fed dropped the funds rate by 50 basis points in the scheduled meeting in September.  My guess is that even the transcripts at the September and subsequent meetings will show that FOMC members did not believe that this money market turmoil would create a hard landing for the overall economy.

It should not be surprising that economists and regulators did not see the crisis coming.  Not too many people did.  But the problem is that part of the legislative and regulatory response to the crisis is to put more responsibility and authority in the hands of the Fed and other regulators.  There is no reason to think that FOMC members during the next financial crisis will be any better at seeing it coming or taking steps to avoid it.