A long period of unusually low interest rates is changing investors’ behavior and is reshaping the products and the asset mix of financial institutions. Investors of all profiles are driven to reach for yield, which can create financial distortions if risk is masked or imperfectly measured, and can encourage risks to concentrate in unexpected corners of the economy and financial system. Companies and financial institutions, such as insurance companies and pension funds, and individual savers who traditionally invest in long-term safe assets, are facing challenges earning reasonable returns, and so they may reach for yield by taking on more risk and reallocating resources to earn higher returns. The push toward increased risk-taking is the intention of such policy, but the longer-term consequences are not well understood.

Of course, identifying financial imbalances, asset bubbles or looming crises is inherently difficult, as policymakers were painfully reminded during the financial crisis in 2008. Public transcripts of the FOMC’s discussions from as early as 2006 show participants were clearly focused on issues in the housing market and yet did not fully appreciate the risk to the economy from the financial sector’s exposure to risky mortgages.

Accordingly, I approach policy decisions with a healthy dose of humility when considering the long-run effects of monetary policy. We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances. Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels. A sharp correction in asset prices could be destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels.

Simply stated, financial stability is an essential component in achieving our longer-run goals for employment and stable growth in the economy and warrants our most serious attention.

In sum, the Fed's basic strategy for strengthening the economy--reducing interest rates and easing financial conditions more generally--is the same as it has always been. The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools aimed at reducing longer-term interest rates more directly.

Editorial aside:  It is worth noting that Bernanke assigns no role to the increase in the supply of reserves or in the monetary base in his analysis of how the Fed's unconventional measures operate.

Lockhart, when asked about remaining policy tools that could yet boost the slow and shaky U.S. economic recovery, said: "I am simply not of the view that we have exhausted all of our options.

"I think there are monetary policy tools and actions that are still available if the conditions require them."

Other evidence suggests that this downward pressure has had favorable spillover effects on other financial markets, leading to lower long-term borrowing costs for households and firms, higher equity valuations, and other improvements in financial conditions that in turn have supported consumption, investment, and net exports. Because the term premium effect depends on both the Federal Reserve's current and expected future asset holdings, most of this effect--without further actions--will likely wane over the next few years as the effect depends less and less on the current elevated level of the balance sheet and increasingly on the level of holdings during and after the normalization of our portfolio.

Economic theory and practice teach us that monetary policy works best when it is clear about its objectives and systematic in its approach to achieving those objectives. Granting vast amounts of discretion to our central banks in the expectation that they can cure our economic ills or substitute for our lack of fiscal discipline is a dangerous road to follow.

Our balance sheet should not be viewed as a new independent instrument of monetary policy in normal times. The exit principles also indicated the Committee’s desire to return the Fed’s balance sheet to an all-Treasuries portfolio. This re-establishes the idea that the Fed should not use its balance sheet to actively engage in credit allocations.

The crisis, the recession it sparked, and the subsequent slow recovery, especially in the advanced economies, have demonstrated that we have much to learn about the workings and vulnerabilities of our modern, globalized financial system and its interactions with the broader economy. In responding to these stressful financial and economic developments, the Federal Reserve and other central banks have had to deploy a variety of new tools and approaches to carry out their responsibilities regarding monetary policy and the provision of liquidity, tools about which we still have more to learn.

“I don’t think the Fed has run out of bullets,” though there are “costs” associated with its options, Dudley said. The Fed could extend its commitment to keep interest rates low or could embark on another round of so-called quantitative easing, he said.

“There are impediments to growth that somewhat lower longer-term interest rates would not be the antidote for,” Lacker said of the policy, known as Operation Twist. “Our role is fairly limited in terms of increasing growth.”

Federal Reserve Bank of Dallas President Richard Fisher said the central bank has “plenty of ammunition” left if the economic situation turns “horrific,” while reiterating his view the Fed has provided enough stimulus.

“I have real concerns about trying to fine-tune and micro-manage the economy when monetary policy is a blunt tool,” Hoenig said today in an interview with Bloomberg Radio’s “The Hays Advantage” with Kathleen Hays. Efforts to “redefine yield curves” may “introduce new complexities and risk new unintended consequences,” he said.

Asked if the Fed still has the power to deliver momentum to the recovery, Bullard said, “I’m not one to say we are out of ammunition.” Bullard, who is not a voter on the Federal Open Market Committee this year, said the Fed can still stimulate the economy “mostly through balance-sheet policy.”

“The committee has made no decision on ‘Operation Twist,’ so I think the market might be a little bit out in front on this question,” Bullard said. He added that when the Fed last tried this policy, “it didn’t work very well at that time.”

“We very much still expect the economy to recover,” Dudley, 58, said today in response to audience questions after a speech in Newark, New Jersey. Growth during the second half of 2011 will be “significantly firmer” than in the first six months, and the risk of recession remains “quite low,” he said.

"We have plenty of ammunition left."

If additional actions are required, I can assure you the Federal Reserve is not out of bullets. If the anemic growth in the first half of this year is a soft patch in an ongoing, moderately paced recovery, additional monetary stimulus is probably of limited marginal value. But saying this is not the same thing as saying that monetary policy would be ineffective if conditions deteriorate. Expansion of the balance sheet or changes in the composition of the Fed's asset portfolio are available, in my view. These could be quite effective, particularly if done in sufficient size, in the event that the economy retreats back into contractionary territory.

But signs the U.S. recovery is flagging - again - suggest the economy needs more gas, and soon, Chicago Federal Reserve Bank President Charles Evans told a small group of reporters in a joint interview.

"If it were easy to do, if we had a very effective policy tool like a positive funds rate, if we could cut that by 100 basis points, then I would almost surely be advocating something like that," Evans said. "But in the absence of that, I think we have to think about the other tools."

“Balance sheet policy, like all monetary policy, should be conducted in a state-contingent way,” Bullard added. (In other words, policy should be adjusted based on the state of the economy.)