Reviewing the Federal Reserve's minutes from the year of the financial crisis, Jon Hilsenrath of the Wall Street Journal follows the prevailing view that Chairman Ben S. Bernanke "moved with command and authority to steer the economy straight once he recognized what was at stake."
I think that conclusion is overly generous to the former chairman. Yet Hilsenrath is undoubtedly right to say that other Fed policymakers "were focused on the wrong problem for much of 2008. While they worried about inflation, the foundations of the financial system and the broader economy were cracking."
To make better decisions in the future, central bankers need to understand how that error happened. Here are three takeaways from the Fed's deliberations in 2008.
First: Pay more attention to forward-looking indicators than to backward-looking ones. Oil prices had been rising, which made inflation hawks nervous. Market indicators of future inflation, on the other hand -- notably the spread between regular Treasury bonds and the inflation-protected variety -- were crashing. So were asset markets. The story those markets were telling ended up being right.
Second: Be aware that the Consumer Price Index can be badly skewed by a mismeasurement of housing prices. In 2008, the housing component of CPI showed rising prices -- raising the overall number -- even though home prices were actually declining. Again, the effect was to bias policymakers toward hawkishness.
Third: Understand how important it is to shape market expectations. The Fed reduced interest rates in December 2007, but not as much as markets had expected. Stocks fell. In an important sense, the market's interpretation of a policy is, in fact, the policy: If the market thinks the Fed is signaling tighter money in the future, it amounts to tightening money in the present. The Fed spent the summer of 2008 preparing the public for tighter money. Even after Lehman Brothers Holdings Inc. collapsed, the central bank refused to reduce interest rates and continued to warn about inflation. The policy it communicated was probably tighter than it intended.
A Fed that took these three ideas to heart would have been looser in 2008, and spared the country and the world a lot of economic pain. In some future year, they could point in the opposite direction -- and still need heeding.
(Ramesh Ponnuru is a Bloomberg View columnist, a visiting fellow at the American Enterprise Institute and a senior editor at the National Review.)
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