WHEN 2007 began, America's economy was growing strongly even as the nation's housing-market bust was gathering pace. In the summer of that year, housing-market troubles precipitated the beginning of the financial crisis as the market for subprime-backed securities evaporated. And by the end of 2007 America was in recession. Though the most dramatic economic events of the financial crisis and recession occurred later, 2007 was the year the storm began, and so it is exciting to finally have access to the full transcripts of the meetings of the Federal Reserve's Federal Open Market Committee, which are released on a five-year lag.

With the release of the transcripts, most of the world of economics journalism has begun hunting for evidence the Fed was underestimating the lurking danger. Such passages make for gripping reading, but it's worth remembering that the best indicator that the Fed underestimated matters was the occurence of a massive crisis and recession. And while it's hard to do, one should also extend some charity to the members of the FOMC. We all know what was to come, and so every optimistic statement, every jocular dismissal of the financial threat, looks like a damning failure of foresight. But though lots of people were worried in 2007, the overwhelming consensus across the economy, from top to bottom, was not that the worst crisis since the Depression loomed (had that been the view, the crisis would have occurred in 2007 rather than 2008). A major economic crisis and recession is, almost definitionally, one that wasn't adequately anticipated before hand.

With that said, there are interesting things to be learned from these meetings. I'll just highlight a few. First, the Fed was not really that far behind the curve in recognising the potential for major financial market disruption. As early as the August meeting, there was concern expressed that trouble in the market for commercial paper could endanger money market mutual funds, possibly leading to losses on those funds ("breaking the buck") which would be very destabilising for the financial system. That, of course, is what occurred in the wake of Lehman's failure in September of 2008. The Fed does lag behind the curve in terms of its financial-market interventions, but (I think) for understandable reasons. The Fed was concerned about overreaction, both because of moral-hazard worries and because of the potential for a public backlash.  In the early stages of the crisis (remembering to control for hind-sight bias) that seems  to me a forgiveable sin.

What is perhaps less forgiveable is the Fed's tendency to ignore its role in markets and the economy in analysing potential outcomes. As is occasionally pointed out in the meetings, financial crises are multiple equilibria creatures; that is, if no one expects a crisis then solvent firms don't face liquidity problems and remain solvent, but if a crisis becomes expected they do and don't. That makes expectations for both financial-market stability and the broader economy very important. Some FOMC members get this. In a December conference call, Timothy Geithner (at the time president of the New York Fed) notes: 

Its fundamental cause, as many of you have said, is this interaction between macro uncertainty and fear about the likely bout ahead for housing and the U.S. economy and the attendant losses for financial institutions.

And yet, the Fed spends the second half of the year focused much more heavily on liquidity conditions in markets than on the macro picture. Housing losses, and by extension the severity of the crisis, look a lot different when the economy is growing strongly relative to when it's recessing. But what you don't much hear from FOMC members is the view that recession prevention should therefore be paramount, lest the Fed find itself needing to prop up the whole of the banking system (which eventually it did, of course).

I am surprised at how long it takes the Fed to grow really concerned that financial troubles might bleed into the broader economy. In August, when mortgage markets begin to freeze up, you do hear worries that this will affect mortgage credit and, via that route, the macroeconomy. In August, the Fed tweaks its language to note that downside risks to growth "have increased appreciably". But while it decides to cut the discount rate to address bank-funding issues it leaves the federal funds rate unchanged. 

As it turns out, the economy slowed "appreciably" from the second to the third quarter of 2007. Now, the Fed doesn't get output data in real time. But markets weren't bashful in providing a real-time picture of their economic outlook. Equities tumbled in July. Perhaps more importantly, market-based measures of inflation expectations dropped rapidly through July and August. The Fed's August liquidity operations didn't alter the downward trajectory of inflation expectations; only with the first rate cut of the cycle, on September 18, did expectations recover. But by that time a broader slowdown in the economy was well underway. Hiring slowed dramatically from the first half of 2007 to the second and the pace of decline in home prices rose. That nudged financial markets toward the bad equilibrium.

Two other notes. First, at this point in the crisis one can already see the need for better communication about the Fed's macro goals. In August, Ben Bernanke says:

It is possible that, given what the markets are discounting for future actions, they’ll be disappointed with this statement, and we might even get a de facto tightening. But I think we just need to state an accurate expression of our views at this time.

As market conditions deteriorated, markets began to price in a rising probability of rapid monetary easing. Mr Bernanke is acknowledging that if the Fed notes the deterioration in economic outlook but provides less easing than the market expects then rates will move in a way that effectively tightens monetary policy. That's very obviously not something you want to have happen amid a brewing financial crisis, and yet Mr Bernanke seems fairly sanguine about it.

The disappointment here would emerge because markets would perceive the Fed to be charting a weaker economic path than had been expected. The question then becomes: why would the Fed do that? The answer, I think is that in the absence of a clear nominal target that directly shapes Fed policy, the Fed has to rely on the signalling power of a given intervention to communicate what it wants. It isn't going to simply say that the goal is to keep to a nominal output level target, for instance, and that over time policy will be precisely as easy as it needs to be to get there. Instead, markets are left inferring the Fed's desired nominal output path based on its actions. Put differently: with an NGDP level target, disappointingly tight policy one meeting implies correspondingly loose policy at the next as the Fed works to fix its error. In the absence of such a target, disappointingly tight policy one meeting leads everyone to revise down expected NGDP growth, which is bad.

Of course, the change to nominal output as a policy target was nowhere on the agenda in 2007. That's unfortunate given the background increase in inflation due to soaring energy prices. Those price increases led some on the FOMC to strike a hawkish tone despite the macro gyrations. Had the Fed been targeting NGDP, by contrast, it would have looked beyond the energy-price increases and focused instead on trying to stabilise demand.

In any event, the transcripts make for interesting reading. But next year will be the real prize, as the FOMC struggles to deal with a collapsing banking system and the descent into the fastest output contraction since the Depression.