Should we view the current developments and concerns in credit markets as a wholesale reassessment (or repricing) of risk by investors, and are the recent problems related to securitizing assets likely to have a longer lasting impact on the economy or financial markets?

I think the answer is no, investors are not reassessing risk in a wholesale way. Consider that a variety of assets that normally are impacted by investor desire for risk reduction have shown little reaction to current problems. For example, if one looks at emerging market debt, or stock prices in emerging economies, the current problems have left little trace in the data. Prices for stocks in many emerging markets are close to or at their highs for the year.

By contrast after September 11, 2001 and during the problems triggered by Long-Term Capital Management, stocks in many emerging markets fell sharply. Similarly, emerging market debt has shown only a modest widening of spreads. Following the September 11 attacks and during the Long-Term Capital Management problems, emerging market interest rates rose sharply.

Short-term debt markets, where relatively low risk financial assets are traded primarily between large financial institutions, are experiencing significantly reduced volumes and unusually large spreads. This is consistent with liquidity problems rather than a change in the willingness to hold risky assets in general.

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.

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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.

I nevertheless considered the larger-than-usual cut in the funds rate prudent because of two features of the current environment. First, the stance of monetary policy before the September meeting was probably a bit on the restrictive side, at least according to many estimates of the so-called “neutral” or “equilibrium” federal funds rate. In fact, the stance of policy was growing more restrictive as core inflation gradually trended down. Second, with the economy operating near potential and inflation well contained, a case could have been made that the funds rate would need to move down toward a neutral stance, even if there had not been a financial shock.

Current difficulties afflicting the real estate sector have, to date, been confined to the residential sector; business outlays for structures have been quite strong. Since its peak in 2005:Q4, real residential fixed investment expenditures have declined by 19 percent. Over the same interval, real business investment in structures has increased by 21 percent. If you plot these two series on a chart, they would look like scissors: one line going up and one line going down—and their slopes would be quite steep. Indeed their slopes suggest that the current rates of change are not sustainable. Housing will not continue to fall at double-digit rates, and outlays for business structures will not continue to increase at double-digit rates.

Unfortunately, recent events suggest that housing will remain weak for several more quarters; stabilization may not begin until well into 2008. Probably the most important statistics in this regard are the number of unsold new homes still on the market relative to their current sales rate and the recent trends in house prices.

The financial market turmoil that began in August hit hard an already struggling housing market. Financial markets appear to be stabilizing, but they have not returned to normal and are still fragile. Most forecasters have reduced their expectations for GDP growth and believe that downside risks have risen. However, the employment report for September, the latest available at this time, does not suggest that the downside risk is occurring. As an aside, the substantial upward revisions to data released in the August report remind us that it is a mistake to place too much weight on any one report.

The Federal Reserve has neither the power nor the desire to bail out bad investments. We do have the responsibility to do what we can to maintain normal financial market processes. What that means, in my view, is that we want to see restoration of active trading in assets of all sorts and in all risk classes. It is for the market to judge whether securities backed by subprime mortgages are worth 20 cents on the dollar, or 50 cents, or 100 cents. Obviously, the market will judge different subprime assets differently, based on careful analysis of the underlying mortgages. That process will take time, as it is expensive to conduct the analysis that good mortgage underwriting would have conducted in the first place. Although there is a substantial distance to go, restoration of normal spreads and trading activity appears to be under way, and we can be confident that in time the market will straighten out the problems. We do not know, however, how much time will be required for us to be able to say that the current episode is over.

Econometric models can estimate approximate effects on the overall economy from changes in real estate activity. Still, economists know that our knowledge is incomplete. It is no secret that the downturn in residential real estate activity is more severe than most forecasters expected only a few months ago.

In the business sector, balance sheets are in good shape, and most firms are not likely to face an appreciable tightening of credit availability.  As a result, I anticipate that they will expand their investment spending to keep pace with rising household demands and with strength in export markets.  In sum, once we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment.

The economy "probably had decent growth" in the third quarter of "three percent-plus," he said. He said it's "too early to tell" about the fourth quarter but said, "I expect growth to slow" in part because of consumer and business caution.

As for the first quarter of next year, Fisher said, "we'll have to see how the economy's recuperative powers are."

From Q&A session, as reported by Market News International

We have tentative signs that the financial markets are beginning to recover from the recent upset, but financial fragility is obviously still an issue.  If the upset were to deepen in a sustained way, it might have serious consequences for employment stability.  As of today, we just do not know what the consequences may be.  My best guess is that the inherent resilience of the U.S. economy along with future policy actions, should they be desirable, will keep the economy on a track of moderate average growth and gradually declining inflation over the next few years.    

It is important to understand that the economy is expected to grow more slowly in the coming months, despite last week’s decision to reduce rates. Therefore, I will not be surprised to see weaker statistics making headlines.    

The adjustment process by private investors has increased the risk that banks may increasingly be called upon as backup providers of funding.  The Federal Reserve responded to these developments by providing reserves to the banking system; it announced a cut in the discount rate of 50 basis points and adjustments to the Reserve Banks' usual discount window practices to facilitate the provision of term financing.  In addition, earlier this week, the FOMC lowered its target for the federal funds rate by 50 basis points.  The action was intended to help forestall some of the adverse effects on the broader economy that might arise from the disruptions in financial markets and to promote moderate growth over time.  Recent developments in financial markets, including impaired price discovery, have increased the uncertainty surrounding the economic outlook.  What originated as a liquidity shock could potentially give rise to increases in credit risk.  The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to meet our dual mandate, fostering price stability and economic growth.  

As best we can tell thus far, the imprint of these developments on economic activity appears likely to be most pronounced in the housing sector.  However, economic activity could be affected more severely in other sectors should heightened uncertainty lead to a broader pullback in household and business spending.  That scenario cannot, in my view, be ruled out, and I believe it poses an important downside risk to economic activity.

I anticipate that the core PCE price index will edge down slightly further over the next few years.  This view is predicated on continued well-anchored inflation expectations.  It also assumes the emergence of some slack in the labor market, as well as the ebbing of the upward effects of several special factors-including energy and commodity prices and owners' equivalent rent.    

"Last Thursday, I said in a speech that I have not seen conclusive signs of weakness in the broader economy,'' Lockhart, 60, said at an event sponsored by the Atlanta Business Chronicle. ``Friday's data, however, shows employment was beginning to soften back in June. This news should be evaluated with recently positive reports in retail sales.''    

As reported by Bloomberg News