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 agree that the Fed certainly cannot afford to take for granted that inflation expectations will remain well-anchored.

At the same time, there are downside inflationary pressures relating to the slowdown in the U.S. economy. ... [T]he U.S. economy is particularly exposed to downside risks from the unwinding of the housing bubble and disruptions in financial markets. There is some slack now in the U.S. labor market and, if these downside economic risks materialize, quite a bit more slack could emerge. Even with a flatter Phillips curve, such a development would place some downward pressure on inflation. It is this unpleasant combination of risks to both inflation and employment that the FOMC must balance as it assesses the appropriate path for monetary policy going forward.

In any event, my view is that we should regard recent events in the mortgage market as reflecting the normal process of innovation. The lessons have been expensive and painful, and the pain is not yet over. As with the dot-com bust, where many firms went bankrupt but some sound business models survived, we should expect that successful innovations behind the subprime market will also survive. In time, I believe, we will find that the subprime sector of the mortgage market will be as normal as any other part of the mortgage market.

Looking ahead, I believe resolution of the current financial market problems requires some stabilization of U.S. housing markets. At this time, it's difficult to determine when that stability will materialize.

[L]ower rates are likely to result in higher house prices than would occur in the absence of monetary easing. This should reduce the foreclosure rate and reduce some of the concern that housing problems will become more widespread. Finally, lower rates should result in less unemployment – one of the main drivers in forced sales of houses. Thus, monetary policy actions may significantly reduce the depth of problems, but are of course not a panacea.  

To the extent that the meltdown in the mortgage market has revealed even deeper problems in the financial system, the negative impact on economic activity could be even larger. 

To date, the resulting potential capital constraints are concentrated in the largest banks with the largest exposure to securities tied to subprime mortgages. While some of the capital losses have been mitigated by new capital, the losses in combination with involuntary growth in assets can potentially restrain the willingness of these institutions to engage in activities that would further swell their balance sheet.

Because these institutions are actively engaged in structured products and loans to finance leveraged deals, it is not surprising that participants in these markets are finding tighter financial constraints. For some markets where these banks are major market makers, the unwillingness to further increase balance sheets has impacted the liquidity in those markets.

Many small and medium-sized businesses are not complaining about credit conditions. This reflects the lack of exposure that many small and medium-sized banks had to securitized products or the subprime market. However, should housing prices continue to fall, losses in prime residential mortgages and construction loans are likely to cause these institutions to be more capital constrained. Banks under $100 billion still retain significant exposure to residential mortgages and construction loans which account for 26 percent of assets or $750 billion. Should housing prices continue to fall and the housing sector get worse, it is likely that these institutions will begin being impacted more significantly.

Given the recent difficulty in securitizing troubled or high LTV mortgage credits, and the possibility that many financial institutions will be reticent to lend to risky borrowers in a declining house price market, the housing malaise could be more protracted and the recovery more anemic than we have experienced in previous housing downturns.

You've got an industry here that's in depression ... But we have to be careful that we have monetary policy that is for the entire economy. We can't allow 5% of the economy to so dominate the monetary policy outcome that we forget about the other 95% of the economy.

From audience Q&A, when asked about the housing and residential construction downturn, as reported by Market News International

And while I think the term “debt overhang” is overly broad, a significant number of homeowners are experiencing considerable strain. Finally, in view of my earlier comments about impaired markets and institutions, the possibility of a credit crunch, and its attendant effects on economic performance, cannot be ruled out.

To my knowledge, there is not a precise definition of a credit crunch, but I would describe it as an environment in which quality borrowers find credit either unavailable or available only on very expensive terms. To the extent that such a situation develops, its economic impact is that some investment projects and planned spending will be deferred or delayed for a time because of the difficulty of obtaining financing, resulting in more modest economic growth than would otherwise occur.

These issues are clearly weighing on policy. While such an environment will not be permanent, it could well persist for an extended period because, if credit is in fact restricted by some institutions and in some markets, it will likely take time for potential borrowers to find alternatives and substitutes.

We have a big inventory problem in the residential area and until that inventory gets worked out I think activity in that sector is going to be subdued and the financial difficulties will persist.

From audience Q&A as reported by Market News International

While identifying housing as still a key drag on the economy, he warned, "We must not allow our concern about 5% of the economy to screw up the other 95% of the economy." 

"Consumer debt, putting mortgages aside, is not likely to be a serious issue unless we have a serious rise in unemployment," he said.
"If we get a big decline in employment then there will be further shoes to drop."

From Q&A as reported by Market News International

The housing sector has been and will continue to be affected by the tightening we've seen in lending standards. New home sales have fallen 64 percent from their peak in October, 2005. Home construction is unlikely to bottom out this year, and I expect housing investment to continue to be a drag on growth through at least year-end.

Of course, I know that our economy is confronting a number of challenges as the new year begins. The residential real estate market still appears to be in freefall. In addition, oil prices have risen, and housing and equity prices have fallen. These factors are restraining the economy beyond the housing sector.

My view is that the continued decline in residential investment has heightened the risk of a more significant downturn in the overall economy.  Falling housing prices further weaken the incentives for residential investment, but are also likely to dampen consumer and business confidence and spending.  Furthermore, falling house prices roil financial markets and financial institutions by exacerbating exposures to the housing market.