The line that separates restoring market function from merely redistributing losses and gains is not a bright one. This is the reason that policymakers only rarely and reluctantly intervene in markets.

Also, the distinction between liquidity problems and insolvency is not a trivial one when monetary authorities respond to troubles of market players. The critical evaluation is the systemic risk posed by the failure of an institution.

Some believe the Fed has overreacted. Others have said the central bank has been slow to respond to building problems. And still others have warned that the Fed has crossed lines that define appropriate function.

But from where I stand, Fed actions were taken with a prudent acknowledgement of the unintended consequences that may accompany almost all policy interventions.

A week ago Sunday, the acquisition of Bear Stearns by JPMorgan Chase was announced. Earlier this week, the deal was changed from the original $2 per share to $10 per share, and certain specifics were adjusted. To facilitate this transaction, the New York Fed—through a limited liability company formed for this purpose—will take control of a portfolio of assets valued at $30 billion as of March 14. JPMorgan Chase will bear the first $1 billion of any realized losses in this portfolio, and any gains will accrue to the New York Fed. The arrangement was undertaken with the support of the U.S. Treasury.

This action was taken to bolster market liquidity and promote orderly functioning of short-term funding and credit risk markets.

[It is a] very difficult policy to intervene in the workings of markets at a particular chosen time.

It's difficult to identify, it's difficult to choose timing, difficult to be sure that market forces themselves will not have what
turns out at the end to be a positive effect.

From audience Q&A, as reported by Market News International, saying he's not "comfortable" with the Fed pre-emptively targeting asset bubbles.

While I have not yet changed my opinion that asset-price levels should not be an objective of monetary policy, I am reviewing this conclusion in the wake of the fallout from the decline in house prices and from the earlier collapse of prices of technology stocks. To be sure, it is challenging at best to identify when asset prices have reached excessive levels, to build support for action once identification has occurred, and to implement corrective policy successfully. These are all significant obstacles, and thus it may well be that containing damage as and after prices correct is, in the end, the preferable alternative.

However, I think it is important to consider these conclusions in light of recent events, where it has proven to be neither easy nor costless to deal with the aftermath of unsustainably high asset prices.

The very sophisticated financial community basically decided that this was a steal. They put very significant pressure on the securitizers to produce more paper. I was aware of it at the time. Then the securitizers began to pressure the lenders and underwriting standards became egregious. It wasn't that the Federal Reserve wasn't aware of the problem. What we didn't realize was the order of magnitude of the subprime lending, which started as a niche with no macroeconomic implications to something that became excessive, a huge part of the market that . . . was sold around the world.

Those who argue that you can incrementally increase interest rates to defuse bubbles ought to try it some time. I don't know of a single example of when interest rate policy has been successful in suppressing gains in asset prices.

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

I think I would be a fool not to say that when we get through this and when this mess is cleaned up, I'll have to think about what we went through.

From Q&A as reported by Market News International, on the relationship between monetary policy and asset prices.

I would discourage you from thinking that simply because, or because of, significant action in credit markets like we had yesterday, that suddenly we are going to have an Open Market Committee meeting and that suddenly we are going to move Fed funds rates in response.

We reacted with very deliberate actions that took place ... in a very short period of timeframe, and I think that it shouldn't be the markets' expectation that we will continue to react in that manner.

As reported by Reuters.

[T]here is a risk that an extended period of low interest rates may distort long-run investment decisions; lead to a search for yield that results in excessive risk-taking; and contribute to the development of asset price bubbles.

In my view, these limitations are significant, and they lead me to believe that we should look to fiscal policy to play a more important role in responding to the spillover from a financial crisis. In contrast to monetary policy, fiscal policy can work effectively even when the financial system is impaired, and its effects are felt more broadly across the economy. My own view is that monetary policy may be a good first line of defense, but should not be relied upon too heavily for too long. Of course, we would have to rely less on monetary policy to respond to financial crises if we could, instead, take measures that would reduce the likelihood or severity of financial crises.

I think it is naive to think that creditors will view their investments in the largest financial institutions as truly at risk. Consequently, I do not think that increased market discipline is likely to be the panacea that some believe.

My own view is that we should consider hard-wiring more sprinkler systems into financial markets and insitutions. One obvious area to look is whether we can improve the risk-based capital approach embodied in Basel II. If capital is to function effectively, it needs to rise as risks increase and be depleted as losses materialize. I think we need to look especially at the procyclical behavior of leverage that we have observed in some large financial institutions, In addition, I believe there may be merit in considering formal liquidity requirements, and perhaps loan-to-value ratios for banks and other financial institutions, especially the large institutions that provide liquidity and risk-management products to other financial institutions and financial markets. I also think that it is time we extinguish some of the off-balance sheet fictions that have developed to excess in recent years.

The public policy problem is the danger that, with the sad record of so many mistakes and abuses in recent years, regulatory burdens designed to end the abuses will do so but only at the cost of making subprime lending so costly and risky to lenders that they will have no interest in restoring this market. We should not forget that market discipline imposed by lenders who have suffered extremely large losses is already making it very difficult for anyone to originate subprime mortgages. In time, if new regulatory burdens do not become too great, we should expect to see new practices become standard.

By allowing institutions to finance with the central bank assets they could no longer finance as easily in the market, we have reduced the need for them to take other actions, such as selling other assets into distressed markets, or withdrawing credit lines extended to other financial institutions, that would have amplified pressures in markets. These measures—the Term Auction Facility and swap arrangements—have had some success in mitigating market pressures, in part by providing a form of insurance against future stress. We now have in place a cooperative framework for liquidity provision among the major central banks. And we have considerable flexibility to adjust the dimensions of these liquidity tools. We will keep them in place as long as necessary, and continue to adapt them where we see a compelling case to do so.