Because credit contractions can emerge and spread rather quickly, the central bank must be prepared to act in an aggressive and timely manner to counteract their effects. And indeed, the Federal Reserve's policy actions since last August have been designed to ease the strains in financial markets and to counteract a projected weakening in economic activity.

So a key assumption underlying my 2008 projections is that economic activity is, in fact, highly vulnerable to a significant credit crunch. Because credit crunches can restrain economic activity through channels that are not fully captured by econometric models or historical experience, my forecast builds in a slower growth trajectory for consumer spending, residential investment, and non-residential investment than the model would have called for otherwise. These adjustments, of course, are only an educated judgment. A credit crunch could impose even more restraint on economic activity, presenting a downside risk to my baseline projection.

"I am not forecasting a recession, but an economy that is going to grow slowly" with "downside risks," Pianalto said.

"It's the credit crunch that I currently see that prolongs the slowing" in the economy, she said.

From Q&A as reported by Market News International

As the nation's central bank, the Federal Reserve is acutely aware of conditions in the economy and financial markets and the challenges those conditions pose to the safety and soundness of banking organizations. Accordingly, we have been focusing supervisory efforts on those institutions most exposed to residential and commercial real estate or other sectors that have come under pressure. We are also attentive to those institutions that would suffer most from a prolonged period of deterioration in economic conditions. We continue to focus our examinations on the financial condition of banking organizations--including the adequacy of their liquidity, capital, and loan loss reserves and their consequent ability to recognize additional losses. We are also evaluating risk management practices very closely, including scrutinizing governance and controls, given some of the risk management lapses in those areas revealed by recent events

I do think we have tried to position ourselves with the extra push from fiscal policy that you folks and the House and the President put together for the second half of the year that the economy is in a position to rebound later this year. I think at the same time, as Chairman Bernanke pointed out, there are downside risks to this forecast and a lot of it comes from the financial market dynamics that we're talking about today.

From Q&A as reported by Market News International

The current economic environment does have some extraordinary features, namely the tremendous difficulties that are affecting the smooth working of capital markets. Some interest rate spreads remain high, and financial capital has taken serious hits at a number of institutions. Thus, I believe we are in a situation where monetary policy cannot be made by focusing solely on inflation and deviations of output from potential. The current turmoil in financial markets has already had a significant impact on the economy and has the potential to continue to restrain economic growth going forward

Once the genie is out of the bottle, it's hard to get it back in. We can't wait too long for inflation expectations to materialize; otherwise we'll get behind the curve.

From press Q&A  as reported by Market News International

[G]enerally favorable economic conditions should help improve financial market stability. In recent quarters, economic growth has slowed considerably. The Federal Open Market Committee (FOMC) lowered the federal funds rate from 5.25 percent last September to the current level of 3 percent. This reduction should encourage stronger economic growth in the second half of 2008.

Looking ahead, I believe resolution of the current financial market problems requires some stabilization of U.S. housing markets. At this time, it's difficult to determine when that stability will materialize.

[L]ower rates are likely to result in higher house prices than would occur in the absence of monetary easing. This should reduce the foreclosure rate and reduce some of the concern that housing problems will become more widespread. Finally, lower rates should result in less unemployment – one of the main drivers in forced sales of houses. Thus, monetary policy actions may significantly reduce the depth of problems, but are of course not a panacea.  

A critical factor in the size of losses, and whether balance sheet constraints become more widespread, is the extent to which housing prices fall. Unfortunately, we have little historical precedent for sustained declines in national housing prices, which makes it difficult to forecast future home prices. However, one of the significant downside risks to the economy is that further declines in housing prices could depress residential investment, reduce consumer spending, generate elevated foreclosures, and contribute to financial instability. Taking appropriate monetary, regulatory, and fiscal actions to mitigate this risk seems prudent.

Given the recent difficulty in securitizing troubled or high LTV mortgage credits, and the possibility that many financial institutions will be reticent to lend to risky borrowers in a declining house price market, the housing malaise could be more protracted and the recovery more anemic than we have experienced in previous housing downturns.

[A]fter growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity slows and funding becomes harder to obtain, especially for more speculative projects.    

A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures. 

The economy is clearly anemic. We're going to have a period of substandard growth that'll stretch for a couple of quarters, if not a little bit longer. At the same time, we do have worse numbers than we had before on the inflationary front. It's always dangerous in this business to do what I think is an oxymoronic thing which is instant analysis. You have to really study the entrails of all the new numbers that have come through. I think it's too soon to form a judgment as to whether the economy is indeed weaker than I expected or inflation pressures are worse than I expected. But clearly the numbers that have come through indicate that we're in for a period of prolonged, slow, economic growth

It's no question that in a globalized economy, whereas before we were the beneficiary of tailwinds that helped us with new labor supply feeding into our productivity here in the United States, now we're facing headwinds based on demand-pull inflationary forces with these 3 billion plus new consumers around the world. So I'm more concerned about inflation than I have been of late. It's a growing concern.