As the nation’s financial system teetered on the brink of collapse seven years ago, top officials at the Federal Reserve huddled inside their marbled headquarters in Washington to brainstorm what it would take to save the American economy.
They called it “blue-sky thinking,” and then-Fed Chairman Ben S. Bernanke led the exercises. The goal was to come up with the most creative, most aggressive, most powerful strategies the central bank could pursue to fight the worst economic downturn in nearly 70 years. The list was long, and freed from the political and financial constraints of the real world, the suggestions at times felt faintly fictitious.
But in fact, the country would require more help than the Fed ever imagined.
The central bank’s stimulus campaign was more massive and lasted longer than anyone had anticipated. The brainstorming sessions generated many of the ideas the Fed initially deployed to arrest the financial crisis. But even blue-sky thinking didn’t anticipate the grinding pace of the nation’s recovery, and officials repeatedly found themselves reaching beyond the horizon.
Their historic effort is finally coming to an end. This month, the central bank announced it is beginning to phase out its support for the American economy. This is the final tally of its work: Seven years with the Fed’s influential interest rate at zero. A $4 trillion balance sheet, more than quadruple the previous size. And an assurance that the return to normal — whatever that means now — will be gradual, to limit any pain.
“I thought the recovery would happen more quickly,” said Don Kohn, second-in-command at the central bank during the crisis and now a senior fellow at the Brookings Institution. “I wouldn’t have guessed in the fall of 2008 that it would be seven years before interest rates rose again.”
Humility, he said, was one of the most important lessons of what has been an unprecedented era of easy money.
“Never be too sure of yourself,” Kohn said. “I don’t think we were.”
The financial crisis unfolded fast and furious, but the recovery has been a slow burn.
Over a single weekend in September 2008, the collapse of investment bank Lehman Brothers and turmoil within insurance giant AIG whipsawed the American economy. The typically staid Fed sprung into action, improvising new tools to avert what might have been another Great Depression.
It launched emergency lending programs to backstop the financial system, including the controversial $800 billion bailout of the nation’s biggest banks. It slashed the target for the interest rate that banks charge to lend to each other overnight — the federal funds rate — all the way to zero in hopes of unclogging the credit markets that keep the economy humming. And it began buying the mortgage-backed securities that precipitated the downturn as panicked investors fled the market.
It all went down within just four months.
“It was kind of like if you’re in a car wreck. You’re mostly involved in trying to avoid going off the bridge,” Bernanke reflected last year at the Brookings Institution in his final public appearance before stepping down from the top job. “And then later on, you say, ‘Oh, my God.’ ”
It worked. Even the Fed’s most ardent critics — on Capitol Hill, in academia, even inside the central bank — praised officials’ quick thinking. Bernanke’s memoir of the period is titled “The Courage to Act.” Less than a year after the “Lehman weekend,” America’s recession was officially over.
The recovery, however, proved disappointing. Central bankers are fond of analogies, and they often likened the nation’s economy to a patient who had left the emergency room but remained stuck in the hospital. And even the most potent medicines could not return the economy to full health.
Tens of thousands of people continued to lose their jobs for more than a year after the recovery began. The unemployment rate peaked at 10 percent in fall 2009. A record proportion of workers were out of a job for six months or longer.
The Fed was overly optimistic from the start. In March 2009, Bernanke said “green shoots” were emerging as mortgage rates fell and business lending picked up. Staff forecasts at the time predicted economic growth would rise to nearly 4 percent in the next two years and top 5 percent by 2012.
Yet even now, the recovery has not reached those speeds, stuck instead at a roughly 2 percent annual pace. The Fed has had to repeatedly move the goal line.
“When the Federal Reserve, or any central bank, pushes its rates close to zero, its power to boost the economy ebbs — not ends, but ebbs,” said Princeton University economist Alan Blinder, who served as Fed vice chairman in the 1990s. “That’s one reason we’ve stayed in the doldrums so long.”
After lowering its benchmark rate to zero in 2008, the Fed wanted to convince markets that it would stay there for a long time. Exactly how long was a matter of debate.
In 2011, it vowed to hold the rate at zero until at least mid-2013. Then officials moved the date to 2014 — and again to 2015. Finally, the Fed gave up on a timeline and instead committed to keeping the target rate steady at least until the national unemployment rate fell to 6.5 percent or inflation rose above 2.5 percent. In reality, rates remained at zero for even longer than that.
Meanwhile, the Fed sought other ways to jump-start the recovery. It ramped up the amount of money it pumped into the economy by buying long-term assets, a strategy known as quantitative easing. The initial round of purchases, launched during the crisis, totaled $600 billion of mortgage-backed securities and debt of housing giants Fannie Mae and Freddie Mac. It expanded the effort several times through 2010 until the total reached about $1.7 trillion.
But just months after the Fed ended the program, it was clear the economy needed more help. It launched a second round that fall and announced a third in 2012. Together, they added up to more than $2 trillion in economic stimulus.
Bernanke likened the programs to booster rockets that would propel the recovery forward. Skeptics say they worked more like a hoverboard, just keeping the economy afloat. Washington also thwarted the recovery with deep government spending cuts and partisan brinksmanship that threatened the nation’s credit rating. Overseas, Europe’s fragile economic and political union nearly came undone — twice — as countries buckled under crippling debt.
“We weren’t fortune tellers, you know,” Bernanke said in an interview with The Washington Post in October. “I think it is important to note that the U.S. recovery, while not all we would like, looks pretty good compared to the rest of the world.”
Seven years to the day after the Fed took its benchmark rate all the way to zero, Chair Janet L. Yellen announced that the central bank is starting to reverse course. The Fed raised its target rate by a quarter percentage point this month, the beginning of the end of its long campaign to revive the American economy.
Yellen cast the decision as a sign the recovery has taken root and can withstand the growing headwinds from plunging oil and commodity prices and a slowdown in China.
“I feel confident about the fundamentals driving the U.S. economy,” Yellen said in a news conference after the announcement. “There are pressures on some sectors of the economy, particularly manufacturing and the energy sector . . . but the underlying health of the U.S. economy, I consider to be quite sound.”
Recent research by senior Fed economists suggests that the full force of the Fed’s stimulus is only just awakening. Its impact on unemployment peaked early this year, lowering the jobless rate by 1
San Francisco Fed President John Williams could see the Fed’s policies seeping into the economy early this year. His wife teaches nursing, and the couple have watched firsthand the surge in the health-care sector, where wages are rising and workers are in demand. The tech companies in Williams’s district tell a similar story. Construction cranes line the city blocks near the bank’s offices. In an interview at the start of the year, he was hopeful that normal was near.
“Policy is extremely stimulative, and that’s been helpful,” Williams said. “But you can’t keep that stimulus forever.”
Traditional economic theory holds that inflation picks up when unemployment falls, as workers gain more leverage to demand higher pay. But the opposite has occurred this year: At 5 percent, the jobless rate has dropped to what the Fed once thought was its lowest sustainable level. Instead of moving up, inflation has gone down, resting at a virtually nonexistent 0.4 percent.
Falling oil and commodity prices coincided with a sharp run-up in the value of the dollar. But the Fed wants inflation to be 2 percent, the level generally associated with a healthy economy. And some officials began worrying that a rate increase could prevent it from achieving that goal.
The picture grew even more complicated when global financial markets swung wildly over the summer after China devalued its currency. On Wall Street, the Dow Jones industrial average dove 1,000 points in one day. Pressure began to mount for the Fed to delay an increase in interest rates, as the International Monetary Fund, the World Bank and a laundry list of prominent economists urged caution.
At the central bank, the outlook was less dire. Richmond Fed President Jeffrey Lacker was ready to begin pulling back the central bank’s stimulus over the summer, and he was unswayed by the volatility in the markets.
Lacker has long been skeptical of the benefits of the Fed’s easy money and concerned that years of stimulus might be distorting the economy. In the 1960s, the central bank tested how low it could push the unemployment rate and ended up stoking the rampant inflation of the 1970s. More recently, some economists have argued the Fed was not aggressive enough at reining in the boom of the 2000s — and wound up sowing the seeds of the bust.
“This whole thing — is it different or not?” Lacker said in an interview this month. “That’s the big gamble now.”
For most of this year, he was willing to compromise. But when the Fed decided to hold off on hiking its target rate in September, he voted against the decision. It was the first dissent of the year.
“This is going to be a year I can’t hide,” he said earlier. “I think it’s very true that we often wait too long and get behind the curve. I’m very attentive to that risk.”
Lacker was not the only one. Cleveland Fed President Loretta Mester said she was ready to move as early as summer. Also St. Louis Fed President James Bullard, who in an interview, called September’s delay “a mistake.” However, neither official was a voting member of the Fed’s policy-setting committee, whose seats rotate among the central bank’s top brass.
The decision came down to the Fed’s final meeting of the year. This time, the vote was unanimous: hike.
“I guess the word is ‘finally,’ ” a reporter told Yellen during the news conference following the announcement.
There are hints of new bubbles emerging. Two of the Fed’s staunchest supporters of stimulus, Williams and Boston Fed President Eric Rosengren, warned that years of low rates may have driven investors to seek bigger returns in riskier corners of the market, such as commercial real estate. Many others turned to high-yield junk bonds, which came under pressure this month after large losses at one prominent fund, Third Avenue Capital, forced it to bar investors from pulling out.
But if the past seven years have proven anything, it’s that the biggest danger is often the one that no one sees coming.
“You have to worry, otherwise you can’t be a central banker,” Fed Vice Chairman Stanley Fischer said in a speech this month. “What worries me most is that things happen: You’ve got a nice framework. It’s all organized. You’re going down this path, looking left, looking right — something hits you right in the back of the head.
“That’s what most frightens me. What are we missing?”