[A]s we learned from this most recent crisis, emerging risks can be hard to judge and it can be even harder to determine what action should be taken ahead of any obvious or near-term threat. In addition, riskier financial activity can grow outside the regulated sector. For these reasons, asking bank regulators and supervisors, or the newly-tasked monitors of financial stability, to single-handedly identify and contain the risks introduced by a highly accommodative monetary policy is not realistic.

In most cases, the use of balance sheet policies for macroeconomic stabilization purposes has reflected the constraints on more-conventional policies as short-term nominal interest rates reach very low levels. In more normal times, when short-term policy rates are not constrained, I expect that balance sheet policies will be rarely used. By contrast, forward guidance and other forms of communication about policy can be valuable even when the zero lower bound is not relevant, and I expect to see increasing use of such tools in the future.

 Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.

This largely paralleled Bernanke's comments in his June 22 press conference.  Bernanke dampened expectations of further asset purchases in the short run in his follow-up testimony to the Senate the following day.

We do have a number of ways of acting; none of them are without risks or costs. We could, for example, do more securities purchases and structure them in different ways. We could cut the interest on excess reserves that we pay to banks. And as was suggested by an earlier question—several earlier questions, actually—Jon’s question about giving guidance on the balance sheet or by perhaps even giving a fixed date, you know, to define “extended period,” those are ways that we could ease further if needed.

But, of course, all of these things are somewhat untested. They have their own costs. But we'd be prepared to take additional action, obviously, if -- if conditions warranted.

The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way because if rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system. And if that market shuts down, if people don't operate in that market, it'll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.

So there's really a technical reason having to do with market function that has motivated the 25-basis-point interest on reserves.

That being said, it would have a bit of effect on monetary policy conditions, and we would certainly -- we're certainly considering that as one option.

From the Q&A session

[T]here is still a lot we don't know about the magnitude and duration of the effects of these policies {Fed asset purchases}. Our standard monetary policy models do not incorporate financial frictions that lead to asset purchases having real effects. We lack both the data and theory to provide strong guidance on these policies. Truly, we are sailing in uncharted waters, marking our maps with every bit of information along the way.

Currently, significant excess capacity in the economy risks lowering inflation and inflation expectations.  Since short-term interest rates are effectively zero, reductions in inflation expectations imply a higher real interest rate – and, effectively, tighter monetary policy.  So the additional clarity on the long-run intentions of monetary policy (as reflected in the longer-range forecasts) might keep inflation expectations well anchored[Footnote 4] and real interest rates low enough to help get the economy moving again. 

An important consideration involves what the long-run goal for inflation should be, given recent experience.  Twice this decade, short-term interest rates have approached zero, and the probability of possible deflation has risen significantly.  In light of this experience, some might conclude that the implicit inflation target has been too low.  A fruitful area for future research would be to re-consider the likelihood and the cost of hitting the zero lower bound, and what that cost implies for setting inflation targets.[Footnote 5]

Other than policies tied to current and expected future values of the overnight interest rate, the Federal Reserve has--and indeed, has been actively using--a range of policy tools to provide direct support to credit markets and thus to the broader economy.  As I will elaborate, I find it useful to divide these tools into three groups...

The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to sound financial institutions.  Over the course of the crisis, the Fed has taken a number of extraordinary actions to ensure that financial institutions have adequate access to short-term credit.  These actions include creating new facilities for auctioning credit and making primary securities dealers, as well as banks, eligible to borrow at the Fed's discount window...

[T]he Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly to borrowers and investors in key credit markets.  Notably, we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds...

The Federal Reserve's third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed's portfolio.  For example, we recently announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters... The Committee is also evaluating the possibility of purchasing longer-term Treasury securities.  In determining whether to proceed with such purchases, the Committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets.

...

These three sets of policy tools--lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities--have the common feature that each represents a use of the asset side of the Fed's balance sheet, that is, they all involve lending or the purchase of securities.  The virtue of these policies in the current context is that they allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound.

In terms economists use, the policy rate has reached its zero lower bound. This situation has raised concerns that the Fed can't do any more to combat recession and that monetary policy—broadly defined—has lost relevance at a crucial point in time. I would argue that a federal funds rate this low will have considerable macroeconomic effect especially if accompanied by policies to improve the functioning of credit markets.

An extensive literature and some recent experience suggest that central bank communications may also play a helpful role in addressing the constraints relating to the zero-bound... [T]he FOMC can work around the zero lower bound on the overnight interest rate by lowering interest rate expectations in the future, thus pushing down longer-term interest rates to stimulate private spending. The Fed employed such an approach between 2003 and 2005, and has taken an important step along the same path in its December announcement by stating that "exceptionally low levels of the federal funds rate" are likely to be warranted "for some time" due to "weak economic conditions." I believe that such statements can play a useful role in more clearly indicating to markets the Committee's own expectations concerning the federal funds rate path, conditional on the Committee's economic forecast.

Communication also can be important in the Fed's efforts to anchor long-term inflation expectations. As I mentioned at the outset, the odds are high that over the next few years, inflation will decline below desirable levels. It is especially important in such circumstances for the Fed to emphasize its commitment to returning inflation over time to the higher levels that are most appropriate to the attainment of its longer-term objectives. A decline in inflationary expectations when economic conditions are weak is pernicious, especially so when the federal funds rate has reached the zero bound, because any downdrift in inflation expectations leads to an updrift in real interest rates and a tightening of financial conditions.

The potential for real interest rates to rise as inflation declines creates a significant downside risk because, with an extended period of abnormally high unemployment in the forecast, it is increasingly likely that inflation will fall to undesirably low levels. This is an additional consideration that, to my mind, militates in favor of strong policy responses.

Evans said that based on the outlook for rising unemployment, falling industrial production and a wider output gap, economic models suggest rates should be below zero.

"If it were not constrained by zero, those models would want to push it below zero, but that's not possible," Evans told reporters after a panel at the American Economic Association's meeting in San Francisco.

Quantitative easing, a way to flood the banking system with large amounts of money, "is a way to mimic below-zero rates and provide support to the economy," he said.

As reprted by Reuters.

Federal Reserve Bank of St Louis President James Bullard said on Saturday that an explicit inflation target would help policy-makers prevent either deflation or inflation from taking hold in the United States.

"An inflation target would help focus expectations," he told a panel discussion during the annual meeting of the American Economic Association.

...

"Maybe now would be a particularly good time to do that because you have this possibility of expectations drifting off to deflation or a lot of inflation. ... I think it would help," said Bullard

The likelihood of further weakening of labor markets, and a reluctance of consumers or businesses to increase spending until economic conditions are more certain, together imply a continued difficult environment for banks.  There are several conditions necessary for financial markets to resume a more normal state, and I would like to briefly discuss each.

First, we need short-term credit markets to return to normalcy. 

...

Second, we need to see some improvement in the housing market before financial markets will resume a more normal state. 

...

Third, officials must take into account – and develop policies and actions that reflect –  the degree to which monetary policy tools are currently deployed.   The stance of U.S. monetary policy reflects our rate reductions, with the Federal Funds rate target currently at 100 basis points.  Given that interest rates cannot be negative, further monetary-policy actions are limited by the zero lower bound for interest rates.  While other monetary policy tools can be employed, increasingly many observers and commentators are suggesting that fiscal stimulus will be an important element of economic recovery.

In response to a question about an ultra-low rate policy:

"I have not been a fan of going to really low levels," Bullard said today in a Bloomberg Television interview.  "Why is it zero this time?  I don't quite get that, though I know some people want to go in that direction."

In response to a question about the implications of the slowdown in money supply growth:

 “If you want to go to quantitative measures, then all of the issues about money come back to haunt you.  You have to talk about velocity and shocks to velocity, and you have to think about all the other things that are going on.  That is a debate that existed in the Eighties and probably sort of petered out in the Nineties, but it might be re-merging now.  But I don’t know exactly how the Fed is going to play that going forward.”

 In response to a question about quantitative easing and unconventional methods.

 “I think these issues are being discussed right now, and I don’t know how it’s all going to come out. I will point out that you have the 1979-82 period and there the famous monetarist experiment, for those of your viewers that were around at that time.  And in that case, gave up interest rate targeting, went to quantity targeting, lots of controversy about exactly how that worked and so and so forth, so it’s been done before.  And you could do it again.”

 “I think the Fed has plenty of tools that we can use.  One of the main things that I’m concerned about is somehow we can communicate what we’re going to do to a private sector that is used to thinking in terms of interest rates, because for the time being it looks like that is going to be off the table for a while.”