Since August 2007, the FOMC's policy decisions have been calibrated to deal with the "adverse feedback loop" between disruptions to financial market stability and the real economy. This focus has influenced not only the setting of the funds rate, but also the implementation of several new policies aimed directly at the financial shocks, some of which I have discussed today.

I believe these initiatives will help in restoring the normal functioning of the financial system. They will also have a stabilizing effect on markets around the world and will therefore eventually help stimulate worldwide economic recovery.

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs.  To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities.  Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize.  In addition, some programs--those authorized under the Federal Reserve's so-called 13(3) authority, which requires a finding that conditions in financial markets are "unusual and exigent"--will by law have to be eliminated once credit market conditions substantially normalize...

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline..  A significant shrinking of the balance sheet can be accomplished relatively quickly. .. as the various programs and facilities are scaled back or shut down.  As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.

Although a large portion of Federal Reserve assets are short-term in nature, we do hold or expect to hold significant quantities of longer-term assets, such as the mortgage-backed securities that we will buy over the next two quarters.  Although longer-term securities can also be sold, of course, we would not anticipate disposing of more than a small portion of these assets in the near term, which will slow the rate at which our balance sheet can shrink.  We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.

Discussions of the role of the central bank as a lender of last resort often appeal to Walter Bagehot’s classic prescription: “Lend freely at a high rate, on good collateral.”⁶ But Bagehot’s teachings are not directly relevant to modern central bank lending. Lending by modern interest-rate-targeting central banks is by necessity sterilized. By itself, a central bank loan increases both the liabilities and assets of the central bank. The additional reserves would tend to drive the interest rate below the target, so central banks generally sterilize their lending operations via offsetting asset sales.⁷ In Bagehot’s time, however, unsterilized lending was the only way for the central bank to prevent a spike in interest rates by elastically increasing the supply of central bank money when the demand for it rose in a crisis. In other words, Bagehot’s dictum was about monetary policy — that is, the size of the central bank’s balance sheet — not credit policy, which alters just the composition of a central bank’s asset holdings.

He acknowledged that the Fed already has "engaged in forms of quantitative easing," and should look at it more "as a contingency plan, should that still remote possibility {of deflation} -- but I think less remote than it was -- occur.

...

The Fed official said monetary policymakers have not switched from using interest rates to quantitative easing, but are employing both.   "I don't think we've given up on one in favor of the other. I think we're doing both at the same time," he said. "So we are lowering our target rate. At the same time we are engaging in a great amount of liquidity provision to the system."

From the audience Q&A, as reported by Market News

The Federal Reserve responded to these developments in two broad ways. First, following classic tenets of central banking, the Fed has provided large amounts of liquidity to the financial system to cushion the effects of tight conditions in short-term funding markets. Second, to reduce the downside risks to growth emanating from the tightening of credit, the Fed, in a series of moves that began last September, has significantly lowered its target for the federal funds rate.

Let me say that looking only at the Federal Funds rate during periods of significant economic headwinds will, in my view, provide a misleading gauge of the degree of monetary stimulus that the Federal Reserve has put in place.  At such times, a low Federal Funds rate does not signal a particularly accommodative monetary policy, but rather offsets some of the contraction that would otherwise occur as financial institutions tighten credit standards and offer borrowing rates with a spread over the Federal Funds rate that is larger than usual (in other words, larger than would be the case outside of credit crunch conditions).

That said, make no mistake: in my view, credit conditions would likely be much worse if the Federal Reserve had not lowered the Federal Funds rate and taken several innovative steps to enhance liquidity in the marketplace – steps like opening our new Term Auction Facility and other facilities that complement our traditional “Discount Window” for banks.

The Federal Reserve's response to this crisis has consisted of three key elements. First, we eased monetary policy substantially, particularly after indications of economic weakness proliferated around the turn of the year. In easing rapidly and proactively, we sought to offset, at least in part, the tightening of credit conditions associated with the crisis and thus to mitigate the effects on the broader economy...

The second element of our response has been to offer liquidity support to the financial markets through a variety of collateralized lending programs. I have discussed these lending facilities and their rationale in some detail on other occasions...¹

The third element of our strategy encompasses a range of activities and initiatives undertaken in our role as financial regulator and supervisor, some of which I will describe in more detail later in my remarks.

Returning the economy to equilibrium requires actions more befitting than changes in the federal funds rate alone. The lending facilities created and employed by the Fed are likely proving useful in this regard. Increasing liquidity by having a central bank lower the federal funds rate can reduce the risk of a more severe financial crisis, but is imperfectly suited to compensate for declines in liquidity arising from retrenchment in the financial sector for long periods.

What about the role of the federal funds rate when the real economy is performing smartly but financial markets are functioning with exceptionally low volatility, and liquidity and credit spreads are extremely narrow? In these periods, the relationship between the federal funds rate and real activity is more difficult to decipher. If abundant credit availability is perpetuated by investor overconfidence, I would submit, policymakers may need to target a higher federal funds rate than otherwise to help the economy attain a sustainable equilibrium. That is, a federal funds rate that is satisfactory in times of normal market functioning may turn out be lower than required to ensure that the economy performs at potential through the horizon. Making that judgment represents an important, but difficult task for policymakers.

And how about when the real economy is operating below-trend in large part because financial markets are impaired, many financial intermediaries are undercapitalized, and risk and liquidity premiums are large and especially volatile? What happens when banks and other financial institutions that stand between the Fed and the real economy restrict the supply of credit beyond that implied by higher premiums or, potentially, economic fundamentals? Should markedly higher doses of monetary medicine (read: lower rates) be proffered to compensate fully for the reduced efficacy of the transmission channels?

Financial turmoil lowers real activity expected to accompany a given level of the federal funds rate. Such a development is equivalent to a fall in the neutral rate. But policymakers should recognize that financial market turmoil is not a garden-variety shock to output. It is different than, say, a demand shock caused by a change in exports. Financial market turmoil can lower output growth and limit the efficacy of the transmission mechanism concurrently. The federal funds rate, I maintain, will generally need to be lowered, and by more than in normal circumstances, to achieve an operative monetary policy rate that helps to restore the economy expeditiously to equilibrium. But policymakers need to think carefully about two issues: the degree of reduction in the federal funds rate and the pace at which the rate returns to normal.

I think it is helpful at this point to note some similarities to the period following the recession of late 1990 and early 1991. You might recall that after the deregulation of the Savings and Loan industry, many S&Ls made imprudent real estate loans. The ensuing losses substantially reduced the lending capacity of the industry as insolvent S&Ls went out of business and others were forced to recapitalize. In addition, banks were reluctant to lend as they struggled to bring their capital in line with the then new risk-based standards set by the Basel I Accords. These restructurings created financial headwinds that made the recovery from recession frustratingly slow. In fact this period was later characterized as a "jobless recovery."

Today, banks again are recapitalizing after making imprudent loans; and again, they are doing so in the face of a sluggish economy. However, one key difference is that today much more overall lending activity is securitized. This has spread losses among a wider swath of financial institutions and has made it more difficult to quantify losses. As a result, we have seen a broader disruption of credit flows, even than those of the early 1990s. This suggests we may again be in for a period of weak growth.

Now let's consider the stance of policy. Today, the nominal funds rate is at 2 percent. In January, projections FOMC members made for PCE inflation in the medium term were in the range of 1-3/4 to 2-1/4 percent. This means the real fed funds rate is close to zero or perhaps slightly negative. Looking back at the early 1990s, the nominal funds rate bottomed out at 3 percent in 1992. Given the higher inflation expectations at the time, this also translated into a real funds rate that probably was close to zero—just like today.

In normal times, a real funds rate near or below zero would be considered highly accommodative. However, then, as now, the boost to aggregate demand from the accommodative funds rate was offset to some degree by financial market turmoil. Because we think the disruptions today are more significant than in the early 1990s, this offset also is larger today. In contrast, today we have in place the various additional measures that provide extra liquidity. No such facilities were in place in the early 1990s. It is difficult to weigh the various factors. But with this difficulty in mind, and given my reading today of economic prospects, my judgment is that the current net stance of monetary policy is accommodative—and this is appropriate in order to address the way we currently see the sluggish economy unfolding in 2008. I also believe that the current stance roughly balances out substantial risks to the outlooks for both growth and inflation—which I see as being to the downside for growth and to the upside for inflation.

You have to put into perspective the way I behaved on fed funds in the context of how the system works or does not work. When we got to 3.5% [at January’s unscheduled policy meeting] and were starting to go below that, my personal bias was to make sure we got all of the plumbing working. The question really is about the efficacy of the system. Will consumers and small businesses benefit from these rate cuts?

When asked about his "strong reluctance" to further easing.

My guess is that a great deal of the potential dislocation resulting from corrective reactions to the subprime boom will be resolved by regulatory initiatives rather than by monetary policy...

Any new regulations that might now be crafted to prevent future recurrences must be well thought out, for two reasons. First, financial institutions will quickly adapt to defeat any regulation that is poorly designed, morphing into new, vaccine-resistant strains. Second, heavy-handed regulations are sometimes worse than the disease against which they are meant to protect. I would be wary of any regulatory initiatives that interfere with market discipline and attempts to protect risk takers from the consequences of bad decisions for fear of creating a moral hazard that might endanger the long-term health of our economic and financial system simply to provide momentary relief.  

In determining the appropriate course for monetary policy, we must recognize that most of the data available now reflect conditions before the disruptions began and, therefore, tell us less about the appropriate stance of policy than they normally would. In addition to data lags, appropriate policy decisions must also, I believe, entail consideration of the role of policy lags--that is, the lag between a policy action and its impact on the economy. Addressing these policy complications requires not only careful and vigilant monitoring of financial market developments, but also the formation of judgments about how these developments will affect employment, output, and inflation. In other words, I believe it is critical to take a forward-looking approach—gauging the effects of recent developments on the outlook, and, importantly, the risks to that outlook.  

My first principle is let markets work.  The second principle is the central bank has a responsibility to promote orderly conditions in financial markets, stepping in as necessary to avoid severe system disruption.  The third principle is to make sure the second principle doesn't undermine our long-term mission.

There are certainly tensions to be resolved in applying these principles, and formulating measured responses to circumstances requires good judgment, particularly in transitional periods.  I believe we are in such a period now.