Where recessions don't matter

The recent release of the 2006 minutes of the Federal Reserve Board - after the standard five-year lag - led many to wonder how the nation's chief financial stewards could have missed signs of the coming Great Recession. An examination of minutes over the last 30 years reveals that they failed to anticipate other downturns as well.

Ever since the appointment of Paul Volcker as chairman in 1979, the Fed has judged inflation to be the major economic threat facing the nation, downplaying the dangers of unemployment and recession. Late that year, the Fed raised interest rates to tackle inflation caused largely by high energy prices and mortgage interest rates. In April 1980, Volcker worried about a possible recession (which soon came), but he was afraid to change course and address it because "it would be interpreted by the financial community as a sign that the Fed was 'quitting premature.' "

The 1980 recession was brief, but so was the recovery. The Fed not only failed to anticipate the 1981-82 recession, the era's largest until the most recent one; it also delayed action once it began. In August 1981, with inflation high, the Fed feared "a great boom" - not the recession that had actually already begun. By March 1982, some of the governors blamed themselves. "I think the state of the economy is ... principally our responsibility, not that of anybody else," said one of them, Lyle Gramley.

Unemployment peaked at 10.8 percent at the end of 1982, higher than at any time since World War II. But it wasn't until the summer of 1982, a year after the recession began, that the Fed began to respond by easing rates.

Yet the bank acted more to prevent systemic collapse than to address unemployment. It was moved by bank failures and a debt crisis in Mexico, whose economy had been wrecked by high interest rates the Fed initiated. Because Mexican loans were held by big U.S. banks, the crisis threatened to bring down the system. The Fed, the Treasury, and the International Monetary Fund arranged a huge bailout. And, quietly, the Fed cut the discount rate and increased the money supply, allowing the U.S. economy to grow.

Similarly, as the economy stumbled in late 1990, the Fed was slow to reduce interest rates, even though inflation was negligible. One Fed staffer remarked, "We can't go out and create a recession to control inflation, but we can try to take advantage of any little recession that happens to come our way."

Even after inflation fell from 3 percent to 2.6 percent during 1993, the Fed raised interest rates, fearing unemployment below 6.2 percent would set off inflation.

So it's not surprising that the Fed characterized the housing crisis of 2006 as a limited risk. For the past 30 years, its assumption has been that if inflation is low, the economy is fine. U.S. economic leaders ignored increasing household debt, the growing trade deficit, rising housing prices, and an outsize financial sector. The prospects of recession, unemployment, and job loss were considered secondary concerns.

Despite all the talk about jobs today, the old priorities are still in place. There is little talk of the dangers of inflation because it's so low, under 2 percent. But the Fed's unwillingness to act more boldly to accelerate growth demonstrates a tolerance for high unemployment that seems embedded in the political culture.

At its most recent meeting, the Fed decided to stay the course despite prospects of elevated unemployment through 2014. In a news conference, Chairman Ben Bernanke refused to say the Fed would tolerate slightly higher inflation to achieve greater employment. Inflation is still in the saddle.