I noted a moment ago that periods of financial instability are characterized by valuation risk and macroeconomic risk. Monetary policy cannot have much influence on the former, but it can certainly address the latter--macroeconomic risk. By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop. The resulting reduction in uncertainty can then make it easier for the markets to collect the information that enables price discovery and to hasten the return to normal market functioning. To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible. Quick action is important for a central bank once it realizes that an episode of financial instability has the potential to set off a perverse sequence of events that pose a threat to its core objectives. Waiting too long to ease policy in such a situation would only risk a further deterioration in macroeconomic conditions and thus would arguably only increase the amount of easing that would eventually be needed.

The need to limit moral hazard by not lending to insolvent institutions indicates that central banks must have information sufficient to determine whether an institution with access to the discount window is indeed healthy.  That consideration is one reason that central banks benefit from having some supervisory responsibility for institutions with access to the discount window (Mishkin, 1994; Bernanke, 2007).   

This brings me to the issue of “moral hazard,” a topic that has been much discussed since the recent financial turbulence began. A concern that is frequently expressed is that an easing of the stance of monetary policy could end up shielding investors who misjudged fundamentals or incorrectly assessed risks from losses and thereby lead them to take inappropriate risks in the future because they think the Fed will act to cushion the consequences of their decisions. I have two responses to this concern. First, the Fed’s policy response will not prevent a repricing of risk from occurring and investors who misjudged risks will surely suffer losses even if monetary policy is successful in keeping the economy on track. Second, I don’t believe that the Fed should stand aside as a financial shock threatens to derail the economy, because that would run the risk of many innocent people being hurt by the loss of jobs and economic well-being. So I believe that, in conducting monetary policy, the Fed should retain a clear focus on how financial market developments are likely to affect employment, output, and inflation and not be concerned with who wins and who loses in financial markets.

Our policy easing was aimed at helping to offset the effects of those tighter credit conditions and thereby to encourage moderate economic growth over time.  It was not intended to, nor should it, short circuit a more realistic pricing of risk and the gains and losses that the repricing will entail for market participants.

First, let me comment on moral hazard...  I did not see the logic of subordinating the general welfare of our nation's economy to the possibility that some participants in financial markets might draw tainted conclusions about the future landscape of risk. My view is that fulfilling the Fed's institutional purposes takes precedence.

The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac are, to a limited extent, assisting in subprime refinancings and should be encouraged to provide products for subprime borrowers to the extent permitted by their charters.  However, the GSE charters are likely to limit the ability of the GSEs to serve any but the most creditworthy subprime borrowers.  Indeed, if GSE programs remove the strongest borrowers from the pool, the risks faced by other programs--such as a modernized FHA program--could be increased.

Some have suggested that the GSEs could help restore functioning in the secondary markets for non-conforming mortgages (specifically jumbo mortgages, those with principal value greater than $417,000) if the conforming-loan limits were raised.   However, in my view, the reason that GSE securitizations are well-accepted in the secondary market is because they come with GSE-provided guarantees of financial performance, which market participants appear to treat as backed by the full faith and credit of the U.S. government, even though this federal guarantee does not exist.  Evidently, market participants believe that, in the event of the failure of a GSE, the government would have no alternative but to come to the rescue.  The perception, however inaccurate, that the GSEs are fully government-backed implies that investors have few incentives in their role as counterparties or creditors to act to constrain GSE risk-taking.  Raising the conforming-loan limit would expand this implied guarantee to another portion of the mortgage market, reducing market discipline further. 

The risk of moral hazard must be considered in designing government-backed programs; such programs should not bail out failed investors, as doing so would only encourage excessive risk-taking. 

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.  

Thus, the Fed does not seek to remove volatility from the financial markets or to determine the price of any particular asset; our goal is to help the financial markets function in an orderly manner. I agree with Chairman Bernanke that we should not seek to protect financial market participants, either individuals or firms, from the consequences of their financial choices.

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.

It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions.  But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.

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Well-functioning financial markets are essential for a prosperous economy… The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets...

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The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

However, it is also possible that the market may be underpricing risk. The long period of financial stability, may be leading investors to expect a similarly benign environment in the future, and therefore to underestimate the probability of the next major disruption. Indeed, conventional applications of risk management tools such as "value-at-risk" typically incorporate only the previous few years of data into their statistical models. A period of sustained stability will cause such models to reduce their estimates of probable losses going forward.

I for one do not think that we have entered a new era of permanent financial moderation. Though our shock absorbers are better, financial volatility has not been abolished. If markets are underpricing risk, then market participants may be too sanguine about their leveraged positions and more vulnerable than they think to the next financial shock. Needless to say, continued vigilance on the part of policymakers and supervisors is needed.

We need to accept that accidents will happen--that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises. But we cannot and should not try to prevent this process through a monetary policy that puts special emphasis on stabilizing asset prices or through regulatory policies that limit access to markets by qualified participants or that attempt to restrain competition materially. Monetary policy that proactively leans against asset price movements runs a considerable risk of yielding macroeconomic results that fall short of maximum sustainable growth and price stability. Regulatory policies that try to prevent failures of core participants or others under all conceivable circumstances will tend to stifle innovation and reduce our economy's potential for long-run growth.

Both market participants and public authorities should understand that, despite our best efforts, crises are inevitable, and so we need to work on crisis management as well. Here, too, cooperation among authorities here and abroad is critical. We must understand the market structures and vulnerabilities and the objectives and constraints under which authorities with different jurisdictions would be working in those circumstances.

Inevitably, uncertainty on the part of market participants and public authorities will be heightened in the event of market turmoil, and that uncertainty can feed on itself. Both authorities and participants need to think through how they will handle such crises. For the authorities, that process includes considering how to resolve any failures of large institutions in ways that impose costs on shareholders and uninsured liability holders while preserving orderly markets. Such a resolution will be necessary to limit the moral hazard of any interventions that we are forced to undertake. Market participants need to consider how they would settle contracts and work with troubled borrowers in a distress situation. More planning will reduce the rise in uncertainty in a crisis and the likelihood that fear will lead to precipitous actions that are in no one's best interest.

At last year's conference, I discussed a policy proposal focused narrowly on hedge funds--namely, the development of a database of hedge fund positions and portfolios. As I noted last year, given the complexity of trading strategies and the rapidity with which positions change, creating a database that would be sufficiently timely and detailed to be of practical use to hedge funds' creditors and investors or to regulators would be extremely difficult. Collecting such information also risks moral hazard, if some traders conclude that, in gathering the data, the regulators have somehow reduced financial risk.