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Transcripts show Federal Reserve underestimated financial crisis in 2007

| Saturday, Jan. 19, 2013, 12:01 a.m.

WASHINGTON — Federal Reserve officials in 2007 underestimated the scope of the approaching financial crisis and how it would tip the economy into the worst recession since the Great Depression, transcripts of the Fed's policy meetings that year show.

The meetings occurred as the country was on the brink of the worst financial crisis since the 1930s. As the year went on, Fed officials shifted their focus away from the risk of inflation as they slowly began to recognize the severity of the crisis.

During 2007, the Fed began to cut interest rates and took extraordinary steps to ease credit and shore up confidence in the banking system. Throughout the year, the housing crisis deepened. Banks and hedge funds that had invested big in subprime mortgages were left with worthless assets as foreclosures rose. The damage reached the top echelons of Wall Street.

At the Fed's Oct. 30 policy meeting, Janet Yellen, then-president of the Federal Reserve Bank of San Francisco, said the economy faced increased risks. But she hardly predicted anything dire.

“I think the most likely outcome is that the economy will move forward toward a soft landing,” Yellen said.

Chairman Ben Bernanke noted that housing was “very weak” and manufacturing was slowing.

“But except for those sectors, there is a good bit of momentum in the economy,” he said.

Bernanke did acknowledge that there was “an unusual amount of uncertainty” surrounding the Fed's economic forecasts.

“In the aggregate data, there is yet no clear sign of a spillover from housing,” he said in summing up the views of the committee.

By December, the economy had plunged into the recession, which would last until June 2009. Five years later, the economy has yet to fully recover.

The Fed did take action in 2007, although investors seemed to think it waited too long. Markets were disappointed when the Fed refused to cut interest rate cuts at its Aug. 7 meeting. After the meeting, the Fed issued a statement declaring that the threats to growth had “increased somewhat.”

At the meeting, various Fed officials signaled their belief that the biggest threat facing the economy was inflation — not slower growth, the transcripts show.

Days later, BNP Paribas, France's largest bank, announced that it was suspending withdrawals from three investment funds, a move that jolted financial markets around the world.

On Aug. 10, the Fed held the first of three emergency conference calls to discuss the emerging crisis. The committee announced that it would pump billions of dollars into financial markets to try to calm turmoil on Wall Street and ease the tightening of credit.

One week later, the Fed called an emergency meeting to slash the discount rate on loans to banks.

Then in September, the Fed cut its key short-term interest rate for the first time since June 25, 2003. The Fed would ax the rate two more times in 2007 as the financial crisis worsened.

Still, the transcripts showed the central bank struggled through the year to develop a clear sense of how serious the unfolding crisis could be and what harm it might do to the U.S. economy.

At the Fed's final meeting of that year in December, the central bank's staff presented an economic forecast for 2008 that proved to be overly optimistic.

And despite concerns about the lending market and the quality of loans, particularly in real estate, Bernanke predicted that no major bank would fail.

“The result of this is that, although I do not expect insolvency or near insolvency among major financial institutions, they are certainly going to become more cautious.”

In March 2008, investment banking giant Bear Stearns was rescued with the help of Fed support. In the fall, mortgage giants Fannie Mae and Freddie Mac were taken over by the government, and the collapse of Lehman Brothers in September 2008 set off a full-blown financial panic.

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