In Part I of this morning's posts on the Federal Reserve, I pointed out that, since World War II, significant housing price drops have always been followed by recessions or been coincident with them.

The Federal Reserve's initial response to the subprime mortgage crisis was to claim last spring that it seemed likely to be "contained":

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency. We will continue to monitor this situation closely.

As unlikely as that seemed to me at the time, I hoped that the experts at the Federal Reserve knew what they were talking about.

When Cerberus was unable to sell its paper to fund the Chrysler deal, the deal went through anyway by extending the bank bridge loans, but the stock market realized that subprime problems had spread to the market for commercial paper and private equity funding. Then it was revealed that the market for mortgage-backed securities was mostly not functioning, which made it difficult for mortgage lenders to raise money by selling off their existing mortgages. High-flying hedge funds and European banks started revealing problems. Unlike in downturns earlier in the year when precious metals, oil, and basic materials stocks tended to rally, in recent downturns harder assets (and stocks reflecting them) started doing poorly as well.

In the face of a credit crunch that was clearly not being contained, nine days ago the Federal Reserve released its decision on interest rates:

Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy. Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures. Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.

Frankly, I was surprised.

Data released in the last few weeks suggest that US inflation is moderating (running only 2.2% year over year) and job growth is slightly softer than expected, giving the Fed plenty of room to lower interest rates. Seemingly informed commentators report that dozens of European and Asian banks probably have nontrivial amounts of subprime paper in their portfolios. The commercial paper market is so frightened that concerns have been raised about whether money market funds can maintain their $1 asset value. Although most commentators say that they will be able to do so, many institutions are reported to be dumping even quality commercial paper in favor of treasury bills and notes in a flight to quality.

It would seem that with housing prices falling, commodity prices falling, stock prices falling, commercial paper prices falling, and CDO prices collapsing, net deflation (rather than inflation) would seem to be the bigger risk. And, of course, the author of the leading policy paper on deflation is none other than Federal Reserve Chair, Ben Bernanke (2002, discussed in Part IV posted below).

In my genuine ignorance, it seemed to me that, even if the Federal Reserve Board had acted promptly in late July or at its August meeting last Tuesday, avoiding a US recession (or a near recession) would be a tough task for the Fed. In a global economy, the Fed has much less control than it used to. By deciding to wait until the subprime mess degrades not only the inputs for economic growth, but economic growth itself, the Fed may decrease the chances that it will ultimately succeed.

Next: The Fed, Part III: Poole Says `Real Economy' Unhurt by Subprime Collapse.