Transcripts: Fed worried inflation in 2002

April 11, 2008 1:12:41 PM PDT
Just-released transcripts show the Federal Reserve was worried about the threat of deflation when it decided to cut a key interest rate by a half-point in November 2002. Then-Federal Reserve Chairman Alan Greenspan called the prospect "pretty scary." Those transcripts, released Friday, showed that Greenspan and his colleagues were focused on what should be done about a sluggish economy and the threat that the country could tumble into a period of deflation, something the country had not experienced since the Great Depression.

While the Fed strives to achieve low inflation, it does not want to see the economy enter a period of serious deflation with the value of real estate and other assets dropping because that sets off destabilizing forces that can have serious consequences. The United States was battered by deflation during the 1930s and Japan experienced a lost decade of growth in the 1990s after its real estate bubble burst, causing a severe bout of deflation in that country.

Some critics have argued that there was never a serious threat of deflation in the United States in the period of the 2001 recession and that the extremely low interest rates engineered by the Fed created a housing boom that drove prices and sales up to record levels only to burst in 2006, sending shock waves through the economy that are still reverberating.

The transcripts released Friday show that Fed officials at the time were not that worried about the effects low interest rates might have, arguing that if inflation started rising, the Fed could reverse course and start raising rates but that a bout of deflation would be harder to combat.

The Fed did cut the federal funds rate, the interest that banks charge on overnight loans, by a half-point at the November 2002 meeting, moving it from 1.75 percent down to 1.25 percent, the lowest level in 41 years. That was the only rate cut the Fed made that year.

During the discussions, Greenspan expressed concern about the country falling into a "deflationary hole."

"It's a pretty scary prospect and one that we certainly want to avoid," Greenspan told other members of the Federal Open Market Committee, the Fed panel that meets eight times a year to set interest rates.

The Fed would cut the funds rate one more time the next year, pushing it to a 45-year low of 1 percent on June 25, 2003. The central bank left the funds rate at that level for an entire year until it began a gradual move to raise rates in June 2004.

While Greenspan was hailed when he left the Fed in early 2006 after 18½ years as chairman for safely guiding the U.S. economy through a number of dangers, the bursting of the housing boom that year and a resulting severe credit crunch have prompted a reassessment of those actions.

But in an interview on CNBC this week, Greenspan said he had "no regrets" about Fed policy during his tenure and said there was little Fed officials or other regulators could have done to avert the housing crisis.

In the interview, Greenspan blamed the housing crisis on "egregious lending practices" in the subprime mortgage market. Critics charge that Greenspan pushed rates too low and left them there too long, fueling a housing bubble that has now burst, causing severe troubles including the possibility that the country has fallen into a recession.

But at the time, Greenspan and his colleagues clearly saw the biggest dangers coming from weak growth and possible deflationary forces.

On the possibility that a half-point cut might be too much, Greenspan said at the November meeting, "It's a mistake that does not have very significant consequences. On the other hand, if we fail to move and we are wrong, meaning that we needed to, the costs could be quite high."

William McDonough, president of the New York Federal Reserve Bank, argued that if the Fed cut rates by only a quarter-point, financial markets would consider Fed officials "a bunch of wimps, which is not an attractive assessment for a group that is supposed to be a very important public body."

Current Fed Chairman Ben Bernanke, a former Princeton economics professor who had joined the Fed earlier that year as a board member, supported Greenspan's recommendation to cut rates by a half-point.

Bernanke said the country seemed to be experiencing the same type of "jobless recovery" that had occurred for a prolonged period after the 1990-91 recession and that a cut in rates was needed to boost growth.

While the Fed releases minutes of its closed-door discussions three weeks after the meetings are held, the full transcripts are only released with a lag of five years.


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