In one popular view, credit market disturbances, such as the recent rise in losses on mortgage-backed securities, cause banks and other credit intermediaries to pull back credit supply as they attempt to repair their balance sheets... An alternative view is that shocks to the economy affect spending more directly, and that as growth declines, the creditworthiness of households and firms deteriorates, causing credit flows to fall and spreads to widen.

...my reading of recent events emphasizes the second view, in which the effect of slowing growth on credit conditions predominates. This view has received much less attention than it deserves, I believe, so let me say a few words about the current cycle in light of this issue.

Personally, I"m concerned about inflation and the negative feedback loop, which is that inflation leads to changes in consumption and business patterns that further retard economic growth as well as to pressures in the foreign exchange markets.

So I think there is a risk of a negative feedback loop that derives from cutting rates. So that's one of the reasons I've been resistant.

My basic point is that a process of deleveraging, in which many financial intermediaries are simultaneously trying to shrink the size of their balance sheets, has produced a situation in which the quantity of credit available in the overall economy from a wide range of intermediaries has contracted sharply and suddenly—a credit crunch. Moreover, concerns about credit quality and solvency for intermediaries can devolve into liquidity problems, as in an old-fashioned bank run. Firms in the shadow banking sector are particularly vulnerable to this because, like banks, they typically issue short-term, highly liquid debt. The fear that an institution may be unable to meet its obligations to its creditors may trigger a withdrawal of credit—as in a bank run. Of course, the perceived inability of one institution to meet its obligations is likely to cast doubt on the ability of others to meet theirs, triggering chains of distress and systemic risk.

The Federal Reserve was created precisely to stem such systemic risks by acting as a lender of last resort, although not since the Great Depression has the Fed acted to accomplish it by lending directly through its discount window to an entity other than a depository institution. Had the Fed not intervened, however, Bear Stearns would have been unable to meet the demands of the counterparties in its repurchase agreements, and thus intended to file for bankruptcy. Doing so might well have led to widespread fears in the financial markets,

What we were observing in U.S. and global financial markets was similar to the classic pattern in financial crises. Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls...

This dynamic poses a number of risks to the functioning of the financial system. It reduces the effectiveness of monetary policy, as the widening in spreads and risk premia worked to offset part of the reduction in the Fed Funds rate.

One of the concerns that I have is that there is some interaction between the credit market situation and the growth situation. That is, if the economy slows considerably, which reduces credit quality, that worsens, potentially, the condition of credit markets, which then may tighten credit further in a somewhat adverse feedback loop, if you will.

 From the Q&A session

Although a firming in the growth of economic activity after midyear now appears the most likely scenario, the outlook is subject to a number of important risks.  Further substantial declines in house prices could cut more deeply into household wealth and intensify the problems in mortgage markets and for those intermediaries holding mortgage loans.  Financial markets could remain quite fragile, delaying the restoration of more normal credit flows.  As observed in the minutes of its most recent meeting, the FOMC has expressed a broad concern about the possibility of adverse interactions among weaker economic activity, stress in financial markets, and credit constraints.

It's not our job to prevent people from suffering losses who presumably knowingly took risks. That's not our job and we certainly don't want to be perceived as having that as our goal, as bailing out people and leading to a psychology in which they feel, 'Don't worry about taking risks in the future because nothing bad could happen because the Fed will bail us out'. That would be very, very bad. That's the moral hazard problem.

...

Our focus has to be on the economy and the innocent bystanders ... Our job is to do our best to create a firewall so the fire
doesn't hurt innocent victims, all the rest of the people in the economy who have nothing to do with this.

From press Q&A as reported by Market News International

My baseline forecast envisions weakness in the first half of 2008 followed by improvement in the second half, with inflation moderating from recent levels. The liquidity injections and easing of monetary policy should help housing and financial markets stabilize and avoid an "adverse feedback loop" in which a decline in housing prices fuels financial market volatility with spillover to the broader economy.    

I see the growth risks as skewed to the downside for the near term. In circumstances like these, we can’t rule out the possibility of getting into an adverse feedback loop—that is, the slowing economy weakens financial markets, which induces greater caution by lenders, households, and firms, and which feeds back to even more weakness in economic activity and more caution. Indeed, an important objective of Fed policy is to mitigate the possibility that such a negative feedback loop could develop and take hold.

[S]trains in financial markets can spill over to the broader economy and have adverse consequences on output and employment. Furthermore, an economic downturn tends to generate even greater uncertainty about asset values, which could initiate an adverse feedback loop in which the financial disruption restrains economic activity; such a situation could lead to greater uncertainty and increased financial disruption, causing a further deterioration in macroeconomic activity, and so on. In the academic literature, this phenomenon is generally referred to as the financial accelerator (Bernanke and Gertler, 1989; Bernanke, Gertler, and Gilchrist, 1996, 1999).

The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.

Financial shocks take many forms. Some, such as in 1987 and 1998, involve a sharp increase in risk premia that precipitate a fall in asset prices and that in turn leads to what economists and engineers call "positive feedback" dynamics. As firms and investors move to hedge against future losses and to raise money to meet margin calls, the brake becomes the accelerator: markets come under additional pressure, pushing asset prices lower. Volatility increases. Liquidity in markets for more risky assets falls.

In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.