These two programs (TAF and central bank liquidity swaps) were designed to stabilize and improve the functioning of the interbank dollar-lending market – indeed, to ease conditions in global dollar markets that were spilling over into our own funding markets.  The Libor rate is now much more aligned with the federal funds rate.  The reduction in the Libor rate helps a variety of borrowers.  Most subprime mortgages have reset rates tied to Libor, many credit card rates are tied to Libor, and the rates on many business loans are tied to Libor.  The actions we have taken are reducing the cost of financing for borrowers and businesses whose rates are tied to Libor and thus influenced by the functioning of interbank dollar lending markets.

In general, the various programs that have expanded the Federal Reserve’s balance sheet should be less attractive to market participants as financial conditions improve. Figure 4 shows that of late, the rate on asset-backed commercial paper has fallen dramatically, and many issuers can receive better terms by issuing commercial paper directly to the market. Figure 5 shows that the prime money market funds have tended of late to have a net inflow of funds, which has helped stabilize short-term credit markets because money market funds are a key investor in these markets.

Federal Reserve Board Chairman Ben Bernanke tried to assure Congress and investors that federal regulators are not grasping at straws in the response to the financial crisis.

"We're not making it up," Bernanke told the House Financial Services panel.

"We're working along a program that has been applied in various contexts," he said. "We're not completely in the dark."

As reported by MarketWatch.

Other than policies tied to current and expected future values of the overnight interest rate, the Federal Reserve has--and indeed, has been actively using--a range of policy tools to provide direct support to credit markets and thus to the broader economy.  As I will elaborate, I find it useful to divide these tools into three groups...

The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to sound financial institutions.  Over the course of the crisis, the Fed has taken a number of extraordinary actions to ensure that financial institutions have adequate access to short-term credit.  These actions include creating new facilities for auctioning credit and making primary securities dealers, as well as banks, eligible to borrow at the Fed's discount window...

[T]he Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly to borrowers and investors in key credit markets.  Notably, we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds...

The Federal Reserve's third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed's portfolio.  For example, we recently announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters... The Committee is also evaluating the possibility of purchasing longer-term Treasury securities.  In determining whether to proceed with such purchases, the Committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets.

...

These three sets of policy tools--lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities--have the common feature that each represents a use of the asset side of the Fed's balance sheet, that is, they all involve lending or the purchase of securities.  The virtue of these policies in the current context is that they allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound.

Let me emphasize that this asset-focused approach is a departure from what the textbooks describe as conventional monetary policy and is not without controversy. Some have called it credit policy to distinguish it from the conventional approach where the central bank achieves its objectives through its influence on bank reserves on the liability side of the balance sheet.

Note that it will not be sufficient simply to roll back the current lending programs when the economy recovers. The precedents that have been set during this episode will influence how market participants expect policymakers to react during the next episode of financial market turmoil. Establishing a coherent and stable financial regulatory regime will require rolling back expectations about how the policymakers will respond to the next financial market disturbance. Rolling back those expectations will be impossible if moral hazard concerns are always set aside in the exigencies of a crisis.⁴

Indeed, a significant feature of the recent financial market stress is the strong demand for dollar funding not only in the United States, but also abroad. Many financial institutions outside the United States, especially in Europe, had substantially increased their dollar investments in recent years, including loans to nonbanks and purchases of asset-backed securities issued by U.S. residents.¹ Also, the continued prominent role of the dollar in international trade, foreign direct investment, and financial transactions contributes to dollar funding needs abroad. While some financial institutions outside the United States have relied on dollars acquired through their U.S. affiliates, many others relied on interbank and other wholesale markets to obtain dollars. As such, the recent sharp deterioration in conditions in funding markets left some participants outside the United States without adequate access to short-term dollar financing.

The emergence of dollar funding shortages around the globe has required a more internationally coordinated approach among central banks to the lender-of-last-resort function. The principal tool we have used is the currency swap line, which allows each collaborating central bank to draw down balances denominated in its foreign partner’s currency. The Federal Reserve has now established temporary swap lines with more than a dozen other central banks.² Many of these central banks have drawn on these lines and, using a variety of methods and facilities, have allocated these funds to meet the needs of institutions within their borders.³ Although funding needs during the current turmoil have been the most pronounced for dollars, they have arisen for other currencies as well. For example, the ECB has set up swap lines and repo facilities with the central banks of Denmark and Hungary to provide euro liquidity in those countries. The terms of many swap agreements have been adjusted with the changing needs for liquidity: The sizes of the swaps have increased, the types of collateral accepted by these central banks from financial institutions in their economies have been expanded, and the maturities at which these funds have been made available have been tailored to meeting the prevailing needs. Notably, in mid-October, the Federal Reserve eliminated limits on the sizes of its swap lines with the ECB, the Bank of England, the SNB, and the Bank of Japan so as to accommodate demands for U.S. dollar funding of any scale. Taken together, these actions have helped improve the distribution of liquidity around the globe.

This collaborative approach to the injection of liquidity reflects more than the global, multi-currency nature of funding difficulties. It also reflects the importance of relationships between central banks and the institutions they serve. Under swap agreements, the responsibility for allocating foreign-currency liquidity within a jurisdiction lies with the domestic central bank. This arrangement makes use of the fact that the domestic central bank is best positioned to understand the mechanics and special features of its own country’s financial and payments systems and, because of its existing relationships with domestic financial institutions, can best assess the strength of each institution and its needs for foreign-currency liquidity. The domestic central bank is also typically best informed about the quality of the collateral offered by potential borrowers.

We will need to decide the appropriate timing of the winding-down of many of the special lending facilities. The actions taken by the Federal Reserve to intervene directly in some financial markets, such as the commercial paper market, are clearly emergency operations only. Except in the most extreme circumstances, when market functioning breaks down and systemic risk reaches unacceptable levels, central banks should distance themselves from decisions about the allocation of credit among private parties.

Another instrument of liquidity provision that central banks are examining is currency swaps to facilitate granting liquidity in other currencies. The central banks found currency swaps useful because the impediments to intermediation in money markets naturally extended to transactions across currencies as well as across maturities and counterparties. Supplying credit in dollars to banks in the euro area and Switzerland helped relieve pressure on those banks and in our markets. In recent months, the Fed was able to make currency swap arrangements on short notice but our reaction time could be even shorter if we keep such arrangements in place or on standby. Thinking carefully about which circumstances in the future would warrant the activation of such arrangements will be a useful form of contingency planning.