We’ve had a wild ride – first a housing boom of epic proportions, then a housing bust, a near-collapse of the financial system, and a terrible recession. Let’s go back to 2006, right before the recession hit. That marked the peak of an unprecedented run-up in U.S. home prices. But the bubble burst. Home prices plunged by over 30 percent nationwide, and even more in states such as Nevada, Arizona, and Florida. As the housing market went into a tailspin, about a quarter of borrowers found themselves owing more than their homes were worth. Delinquencies and foreclosures surged. With millions of mortgages going sour, financial institutions that had placed big bets on home loans posted massive losses. It was like an epidemic. No one knew which financial institutions were infected with toxic assets. Everyone was suspect. Financial institutions were afraid to lend money to anybody, including each other. That choked off the flow of funds that  BIS central bankers’ speeches  1  financial institutions and businesses depend on for their day-to-day operations. The result was a worldwide financial crisis. If left unchecked, this kind of financial panic could have ushered in an economic cataclysm like the Great Depression, when 25 percent of the workforce was out of work. Why didn’t we plunge into the abyss? A key reason was that the Federal Reserve did what it was supposed to do. The Fed is the nation’s government-chartered central bank.
In order to properly understand what happened, we must consider the gradual shift that occurred in expectations and in economic policy during the post-war period. The thinking at the beginning of that period was still marked by the interwar period’s mass unemployment but also by the price stability of that time. Prices fell during some periods and rose during others. On the whole, the price level was stable during the 1930s, which was also the Riksbank’s explicit target at the time. Inflation expectations during the first post-war period were marked by these experiences, even to such an extent that the government prior to the post-war period announced in advance that the price level would fall as the productivity gains from the transition to peacetime production materialised. As the general price level actually rose, but never dropped, the public’s expectations of inflation were influenced accordingly. Expectations of rising prices worked their way slowly into people’s minds. During the period 1956-64, the general level of prices increased on average by 3.4 per cent a year; during the period 1965-74 by 5.6 per cent and from the mid-1970s to the mid-1990s by an average of 8.1 per cent a year. Between 1973 and 1982, Sweden devalued the krona six times after the Bretton Woods system, with its fixed exchange rates, had been abandoned. By the end of the 1980s, following successive increases in the inflation rate and repeated devaluations, inflation expectations had been anchored at a high level.