As an example, one significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levelsfor example, the 1-year nominal rate, 9 years forward is about 3 percent currently. My staffs analysis attributes this decline almost entirely to lower term premia. In this case, the fact that market participants have set forward rates so low has presumably led to a more accommodative set of financial market conditions, such as the level of bond yields and the equity markets valuation, that are more supportive to economic growth. If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher.

Taken together, developments in U.S. bond portfolios do not indicate a worrisome pickup in risk-taking in external investments. But it is important to recognize that portfolio reallocations that seem relatively small for U.S. investors can loom large from the perspective of the foreign recipients of these flows. At roughly $400 billion at the end of 2012, emerging market bonds accounted for a tiny fraction of the roughly $25 trillion in bonds held by U.S. investors. But to the recipient countries, these holdings can account for a large fraction of their bond markets. Even relatively small changes in these U.S. holdings can generate large asset price responses, as was certainly the case in the summer of 2013. Likewise, a reassessment of risk-return tradeoffs could disrupt financing for projects that are dependent on the willingness of investors to participate in global syndicated loan markets.

We take the consequences of such spillovers seriously, and the Federal Reserve is intent on communicating its policy intentions as clearly as possible in order to reduce the likelihood of future disruptions to markets. We will continue to monitor investor behavior closely, both domestically and internationally.

I mean, stock prices have risen pretty robustly, but I think that if you look at traditional valuation measures, the kind of things that we monitor, akin to price-equity ratios, you would not see stock prices in territory that suggests bubblelike conditions. When we look at a measure of what's called the equity risk premium, which is the differential between the expected return on stocks and safe assets like bonds, that premium is not -- is somewhat elevated historically, which again suggests valuations that are not in bubble territory.

MCKEE: Over the next five years, two of your researchers recently published a paper suggesting investors can expect abnormally high excess returns on the S&P. Do you agree with their conclusion?

DUDLEY: I learned not to follow forecasts of the stock market.

MCKEE: They base that on the current equity risk premium, which was 5.4 percent as of December, a record high. Does that concern you?

DUDLEY: Well, the equity risk premium is as high as it is because, one, PE ratios aren't that high. So if we take the price-earnings ratio of the stock market, it's around 16, 17. So you flip that to get the E-to-P ratio. It's around 6 percent. And you compared that to real interest rates. TIPS yields are negative. So that equity risk premium, that difference between the two is very, very wide. So that would argue that the stock market isn't grossly overvalued, but there are other ways of looking at it.

If you talk to Bob Shiller, who's a very respected academic who's looked at the stock market, you look at the stock market relative to the trailing 10-year earnings, the stock market actually looks quite expensive. So it really depends on what framework you use to evaluate the stock market.

However, as subsequent events have demonstrated, the problem was much broader than subprime lending. Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress.

The elevated defaults we have already seen on recent vintages of subprime mortgages have resulted in losses for the highest risk tiers, and have caused investors to sell higher quality securities at a discount, reflecting uncertainty surrounding the accuracy of the investment-grade rating. If the ratings were accurate, highly rated securities containing subprime debt would have only a remote chance of default similar to investment-grade securities containing prime mortgages, home equity loans, or student loans. Unfortunately, underlying assumptions for the subprime market were inaccurate for several reasons I'll describe.

First and most importantly, most parties involved in the process assumed that house prices would continue rising nationally. This assumption seems to have had the biggest impact on the situation we see today. ... Second, the subprime market has grown very rapidly in recent years, so such widespread use of subprime mortgages is a relatively new phenomenon. This limited history made it difficult to assess the likelihood of defaults if underlying economic conditions changed. And third, the increased reliance on mortgage brokers who originated the loans but had little stake after they were securitized was a departure from the traditional buy-and-hold strategy of many financial institutions. These brokers typically are compensated based on volumes of loans made and sometimes on the rates and fees as well; as a result, the brokers have few incentives to worry about the longer-term viability of the mortgage.

Defaults in the subprime market have resulted in even the most secure tranches of subprime securitizations selling at a sizable discount. Investors are now questioning the appropriateness of surrogate securitization, contemplating more independent analysis of the securities and underlying assets and the need to distinguish between securitizations with different underlying assets. These are appropriate considerations, to be sure, but until they are more confident, investors have been shying away from even investment-grade securitization. The problems in securitization are highlighted by the impact on jumbo mortgage loans. Because of difficulties in securitization, the cost of these loans has risen significantly. This is particularly a problem in New England where the price of housing is quite high.

Of course, we all want to consider whether the recent problems related to securitizing assets are going to have a longer lasting impact on the economy or financial markets. Securitizations have made it possible to efficiently finance pools of assets. In particular, investors with low risk tolerance were willing to buy what they thought were investment grade securities without a detailed understanding of the underlying assets as long as they had confidence in the ratings of the securities. To the extent that these investors have less confidence in ratings, they may choose to buy government or agency securities, where they do not need to make an independent analysis of potential credit risk. In part, this accounts for the reduction in rates on government securities relative to other financial instruments over the past two months.

As questions have been asked on ratings of securities, many investors have chosen not to roll over commercial paper that was not backed by solid assets and did not have liquidity provisions provided by banks. This freeze-up, of course, means problems for financing a variety of assets, including mortgages, student loans, and home-equity loans.

...

The alternative to securitizations and financing assets with commercial paper is financing by commercial banks. Fortunately, most banks are very well capitalized and have the ability to finance these assets. In fact, bank balance sheets did expand in both August and September, reflecting in part banks holding assets on their balance sheet that have been difficult to securitize. However, while banks have the capacity to finance many of these assets, it is likely that the cost of financing for these assets will increase if they are done by banks rather than through financial markets.

My expectation is that over time, investors will gain more confidence in their ability to evaluate the quality of ratings, and that conservatively underwritten securitizations and asset-backed commercial paper will find acceptance by investors. A reevaluation of ratings and the models used to determine ratings, and a greater onus on investors to understand the underlying assets and securities they are purchasing is likely to make these markets more resilient. However, this process of evaluation may take some time. While we have seen improvement in financial markets over the past month, we continue to observe wider spreads and reduced volumes on securitized products, which may remain until investor confidence has been restored.

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.

Although this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. In part, these wider losses likely reflect concerns that weakness in U.S. housing will restrain overall economic growth. But other factors are also at work. Investor uncertainty has increased significantly, as the difficulty of evaluating the risks of structured products that can be opaque or have complex payoffs has become more evident. Also, as in many episodes of financial stress, uncertainty about possible forced sales by leveraged participants and a higher cost of risk capital seem to have made investors hesitant to take advantage of possible buying opportunities. More generally, investors may have become less willing to assume risk. Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time. However, in this episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress.

Consider where this analysis leaves us...  The central bank can hold its policy rate relatively steady and rely on market adjustments in long rates to do much of the stabilization work... The current situation is a perfect illustration. The Fed doesn’t know and market participants do not know either, the full implications of last week’s stock market declines and increases in risk spreads. Market reactions last week may be overdone, or perhaps not. We just do not know. In a situation like the terrorist attacks of 9/11, the Fed knew enough to believe that a quick policy response would be helpful and unlikely to itself be destabilizing.

A typical market upset, such as last week’s, is not at all like 9/11. Most of these upsets stabilize on their own, but some do not. I’m not saying that the Fed should ignore what happened last week—we need to understand what is happening. However, it is important that the Fed not permit uncertainty over policy to add to the existing uncertainty. The market understands, I believe, that the Fed will act in due time, if and when evidence accumulates that action would be appropriate. That is why trading in the federal funds futures market reflects changed odds from two weeks ago on a policy adjustment later this year...

The regularity of Fed behavior I espouse is that the Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment, or when financial-market developments threaten market processes themselves... [E]ffects on the economy can rarely be understood without passage of time and more information. Occasionally, there is contemporaneous evidence of damage to market mechanisms that might justify quick Fed action.

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.

Some estimates are in the order of between $50 billion and $100 billion of losses associated with subprime credit products. The credit rating agencies have begun to try to make sure they account for those losses, and they have downgraded some of these products.  I should say that the investors, many of them recognize that even before the downgrades occurred that there were risks associated with these products, including not only credit risks, but also liquidity and interest rate, other types of risks.

However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans.  In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments.  Credit spreads on lower-quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened.  Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk.