Some economists have argued that tighter monetary policy during that period would have led to better outcomes by limiting the housing boom and thus mitigating the subsequent bust.² While I find this view plausible, again, further research will be required to substantiate this hypothesis.

Given the likely drawn-out nature of the prospective adjustments in housing and financial markets, I see the most probable scenario as one in which the performance of the economy remains subpar well into next year and then gradually improves in late 2009 and 2010. As credit restraint abates, the low level of policy interest rates will begin to show through into more accommodative financial conditions. This improvement in financial conditions, together with the gradual stabilization of housing markets and the stimulative effects of lower oil and commodity prices, should lead to a pickup in jobs and income, contributing to a broad recovery in the U.S. economy.

At the same time, inflation seems likely to move onto a downward track. If sustained, the recent declines in commodity prices should soon lead to a sharp reduction in headline inflation. In addition, I expect core inflation to slow from current levels as lower commodity prices and greater economic slack moderate upward pressures on costs. Similar reductions in inflation abroad, as well as the recent appreciation of the dollar, should restrain increases in the prices of imported goods.

I would caution, however, that the uncertainty around my forecast is substantial. The path of the economy will depend critically on how quickly the current stresses in financial markets abate. But these events have few if any precedents, and thus we can have even less confidence than usual in our economic forecasts.

Recent financial developments and economic data make it clear that the outlook for the U.S. economy has weakened noticeably, and inflationary pressures have substantially abated. Coordinated action symbolizes the determination of central banks to act together to address what is now a global crisis. And it diminishes the potential exchange rate repercussions of any single country’s solo action.

I think that today's circumstances align, although not perfectly, with the experience of the early 1990s. There is no doubt that a variety of potential borrowers are finding funding more difficult and expensive to obtain. Moreover, while there was a significant contraction in residential construction activity in the late 1980s and early 1990s, the recent correction in this sector has been more severe, especially with the decline in housing values, and is continuing.

It is important to bear in mind, however, that many “initial conditions” prevailing prior to this financial shock were perceptibly better than in the early 1990s. Unemployment, interest rates, and inflation were all lower at the outset of the latest period of turmoil than in the previous headwinds episode. Equally important, the financial condition of both most banking and nonfinancial businesses was relatively healthier at the onset of recent problems.

In my judgment, the 1990s headwinds episode continues to provide a valuable reference point for thinking about economic prospects. For the near-term, I think that this framework suggests further declines in employment and likely softness in consumer spending, with a diminution of inflation, absent a resurgence in energy and other commodity prices.

Lacker said, however, that the Fed's monetary policy stance is "positioned well for where we are right now," though he admitted he wasn't so sure a few months ago.   "In the middle of the year, I had concerns about where we were for policy, but the weakening in growth we’ve seen in the last couple of months makes me more comfortable about where policy is right now."

As reported by Dow Jones Newswires

The problems relating to the securitization market and the GSEs have reduced the responsiveness of mortgage and other consumer lending rates to reductions in the Federal Funds rate.  It is also a sign of the times that for many borrowers, access to credit may be limited because of an unwillingness to lend to borrowers with troubled credit histories, or because falling housing prices have reduced their ability to utilize home equity lines of credit.  Where credit is available, the yields have remained high despite the reductions in the Federal Funds rate.

That is not to say that monetary policy has been ineffective – quite the opposite, in my view.  The rate easing and liquidity measures undertaken by the Federal Reserve were appropriate and effective, in that credit problems would likely be a great deal more severe, and widespread, had we not taken the steps.

...

While the Federal Funds rate is low by historical standards, I would argue that one cannot capture the stance of monetary policy by only looking at this one rate, particularly during a period when the transmission of monetary policy has been impeded by problems with securitization, financial institutions, and GSEs. 

{The debate over rules and descretion} is always on our minds. And for me, in the present circumstance, it arises in how you calibrate your concern about growth. Real interest rates have to fall when growth slows, but you want to communicate that you're not using your discretion to just shift your attention from one objective to the other. It's important for people to know that we're maintaining a continual focus on inflation. It's just that the state of the real economy justifies lowered growth now. You don't want it to be interpreted as we're throwing inflation overboard for a few months while we worry about growth. So it's letting people know that we're following what we view as a time-consistent strategy to commit to keeping inflation low, and that we're not just acting on a purely discretionary basis.
...
The Taylor Rule has proved incredibly useful as a very convenient way of summarizing algebraically and approximating in a fairly impressively good way, the way central banks behave. But keep in mind that Taylor Rule is a function of just things you can observe. Actual realized inflation recently. And what it leaves out are a lot of things policy makers can observe. What their forecast is, what's going on in oil markets, a lot of other data that go into our thinking, and that can affect our sense of how the economy's going to evolve. And those things, in turn, affect our policy setting. That doesn't mean we throw the Taylor Rule overboard. On the contrary. It's something that you want to deviate from only with good reason and only being very careful. And the farther you get away from it, the more you have to kind of check yourself as to whether you're really on solid ground or not.

This is bigger than the S&L. It's broader. It's deeper.  It's not unhealthy. It's the way capitalism works.

Part of the rationale for the speed with which the FOMC brought down the funds rate was the risk that the slowdown we are experiencing would prove to be more severe. While that uncertainty has not entirely disappeared, my sense is that such downside risks have diminished appreciably. And just as easing policy aggressively in response to emerging downside risks made sense, withdrawing some of that stimulus as those risks diminish makes eminent sense as well. Moreover, our attention to risks needs to be two-sided, I believe. As we move through this period of low growth, we need to be attuned to the risk that we emerge from the slowdown with inflation following a higher trend than when we went in. This danger associated with the persistence of elevated inflation warrants an additional measure of vigilance.

An efficient monetary policy {following an oil shock} should attempt to facilitate the needed economic adjustments so as to minimize distortions to economic efficiency on the path to achieving, over time, its dual objectives of price stability and maximum employment.⁹

In particular, an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation.  By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago.  Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains.

One of the guiding principles from contemporary economic theory is that monetary policy should be conducted in a systematic and predictable fashion.

I do believe, however, that lender-of-last resort policies should take a lesson from what we have learned from the theory of monetary policy. In particular, policy should have important rule-like features. Specifying in advance the conditions or states of the world under which the central bank will lend is an essential first step. But policy must also make credible commitments to act in a systematic way consistent with explicit ex-ante guidelines. Discretion in lending practices runs the risk of exacerbating moral hazard and encouraging financial institutions to take excessive amounts of risk. Nevertheless, the issue of trading off financial stability and moral hazard will likely remain. 

Beyond that, the central bank's historical role as a lender of last resort places it squarely in the center of financial disruptions as they unfold. We are perhaps not as close to a consensus on the proper conduct of this role as we are with regard to price stability. But as we continue to learn about the causes and nature of financial instability, I believe we should strive for policy that is informed by the lessons learned in the achievement of price stability. Chief among those is that a central bank can achieve better outcomes if it can establish credibility for a pattern of behavior consistent with achieving its long-term goals.

The implications of the headwinds for inflation are not so clear, although I would note that the pace of inflation diminished in the 1990s relative to its performance over the preceding several years.

As reported by Market News International.

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.