The Federal Reserve and other authorities also are focusing on enhancing the resilience of the tri-party repo markets, in which the primary dealers and other large banks and broker-dealers obtain very large amounts of secured financing from money funds and other short-term, risk-averse investors. For some time we have been working with market participants to develop a contingency plan should there ever occur a loss of confidence in either of the two clearing banks that facilitate the settlement of tri-party repos. Recent experience, including Bear Stearns' liquidity problems, demonstrates the need for additional measures to enhance the resilience of these markets, including the development of contingency plans for dealing with the sudden loss of confidence in a large tri-party borrower. Given the critical role that these markets play in our financial system, we need to proceed in a prudent manner in making changes, especially as long as the broader financial markets are experiencing stress. Nonetheless, over time, a stronger financial system may require changes in the way borrowers and lenders use these markets, as well as in the settlement infrastructure operated by the clearing banks.

The balance-sheet pressures, and broader financial market dislocations, are likely to be with us for some time. My expectation is that market functioning will improve markedly by 2009. But things could get worse before they get better. For example, home prices could fall more than markets expect, leading to larger losses for financial institutions and further impairing their ability to make new loans. The credit crunch could then lead to further declines in house prices. The resulting decline in household wealth could then further reduce spending, leading to additional knock-on effects. So an adverse feedback loop could develop, with consequences for both financial markets and economic activity.

As market participants take steps to foster greater transparency and reduce the complexity of structured credit instruments, I believe that recovery and repair in the mortgage markets will take hold over time. Moreover, as financial institutions continue to attract capital and strengthen risk-management practices, and as supervisors ensure that banks take the necessary actions, institutions will become more resilient to shocks, and the overall financial system will be more robust as a result.    

Asked if there is any way to pump liquidity into the markets without reinforcing commodities speculation, Rosengren said that, "Unfortunately, we don't have much control over where the money goes after we push it into the market."

The purpose of the liquidity provisioning "has not been to cause commodity speculation," he said. "I think there have been some very beneficial things to come out of liquidity moves."

From Q&A as reported by Market News International

We saw a debauching of the credit system. To correct that, financiers, whether they be banks or homeowners, will be more cautious as they proceed.

As reported by Market News International

I think the Federal Reserve has taken appropriate policy steps to respond to a significant financial shock, the shock that rendered some markets illiquid, and which has affected the economic outlook negatively.

In this environment, policy needs to remain sensitive to evolving financial conditions and to incoming information on business activity.

As reported by Reuters.

The potential for headwinds is integral to thinking about U.S. economic prospects over the next year or two. To the extent that headwinds gain momentum, and we have seen a few squalls already, they suggest relatively modest growth for a time and the likelihood of increases in the unemployment rate.

As reported by Market News International

Timothy F. Geithner, president of the Federal Reserve Bank of New York, and a close Bernanke ally, defines the Fed chief’s “doctrine” as the overpowering use of monetary policies and lending to avert an economic collapse. “Ben has, in very consequential ways, altered the framework for how central banks operate in crises,” he said. “Some will criticize it and some will praise it, and it will certainly be examined for decades.”

Clearly, the market discipline that “sophisticated investors” are supposed to provide was lacking.  As we saw, even some of the largest, most sophisticated financial institutions inadequately incorporated into their risk-management models the full range of hazards entailed in the originate-to-distribute business and the liquidity risks that would result from a drying up of short-term funding. Also lacking were reliable ratings from the agencies. But financial supervisors and regulators, including the Federal Reserve, were behind the curve, as well.  We missed some of the risky developments that were unfolding.  Our consumer regulations were unfortunately insufficient to protect households from some egregious and unfair lending practices. And we took too long to ramp up some supervisory policies in the face of mounting risks.

Challenges in the financial markets will continue. We do see some improvement in many markets. We continue to be very watchful, very mindful of how the markets are evolving.

From Q&A as reported by Reuters.

As market participants take steps to foster greater transparency and to reduce the complexity of structured credit instruments, I believe that recovery and repair in the mortgage markets will take hold over time. Moreover, as financial institutions strengthen risk-management practices and as supervisors ensure that the necessary actions are taken, I expect the financial system as a whole to become more resilient.  

Whether the economies of the rest of the world have successfully decoupled from the United States is a judgment we will have to leave to the economic historians. What I do believe, however, is that our financial markets at the center of this turmoil have not decoupled, not even a little bit. In fact, our financial institutions and financial markets have never been more integrated. Policy differences, thus, should not be taken lightly.

What about the role of the federal funds rate when the real economy is performing smartly but financial markets are functioning with exceptionally low volatility, and liquidity and credit spreads are extremely narrow? In these periods, the relationship between the federal funds rate and real activity is more difficult to decipher. If abundant credit availability is perpetuated by investor overconfidence, I would submit, policymakers may need to target a higher federal funds rate than otherwise to help the economy attain a sustainable equilibrium. That is, a federal funds rate that is satisfactory in times of normal market functioning may turn out be lower than required to ensure that the economy performs at potential through the horizon. Making that judgment represents an important, but difficult task for policymakers.

And how about when the real economy is operating below-trend in large part because financial markets are impaired, many financial intermediaries are undercapitalized, and risk and liquidity premiums are large and especially volatile? What happens when banks and other financial institutions that stand between the Fed and the real economy restrict the supply of credit beyond that implied by higher premiums or, potentially, economic fundamentals? Should markedly higher doses of monetary medicine (read: lower rates) be proffered to compensate fully for the reduced efficacy of the transmission channels?

Financial turmoil lowers real activity expected to accompany a given level of the federal funds rate. Such a development is equivalent to a fall in the neutral rate. But policymakers should recognize that financial market turmoil is not a garden-variety shock to output. It is different than, say, a demand shock caused by a change in exports. Financial market turmoil can lower output growth and limit the efficacy of the transmission mechanism concurrently. The federal funds rate, I maintain, will generally need to be lowered, and by more than in normal circumstances, to achieve an operative monetary policy rate that helps to restore the economy expeditiously to equilibrium. But policymakers need to think carefully about two issues: the degree of reduction in the federal funds rate and the pace at which the rate returns to normal.

Consistent with Munger's admonition, the Fed saw it necessary to expand our toolkit beyond the proverbial hammer of the policy rate in the last nine months. And as I discussed in remarks last month, the Fed's nontraditional policy response included the use of innovative liquidity tools to counter the market turmoil and improve the functioning of financial and credit markets.⁴

In my remarks today, I would like to discuss the use of the hammer--the setting of the federal funds rate--particularly in extraordinary times. Of course, determining the proper level of the federal funds rate is rarely simple, given typical imprecision on key economic variables and relationships. It is far more challenging still when the financial architecture is in the early stages of redesign, the economy is adjusting to the aftermath of a credit bubble (witnessed most acutely in the housing markets), and inflation risks are evident.

The Federal Reserve has employed the hammer with considerable force in the last nine months, lowering the federal funds rate by 3-1/4 percentage points, with wide-ranging implications for the economy. Of substantial import, we have filled the toolkit with other implements to provide liquidity and improve the provisioning of credit during the turmoil. But now, policymakers may be well served encouraging a new financial architecture to emerge, aided, in part, by the actions we have taken. Even if the economy were to weaken somewhat further, we should be inclined to resist expected, reflexive calls to trot out the hammer again.

Policy actions should reinforce the notion with stakeholders that further hammering needs to be done, but it needs to be accomplished by the financial institutions themselves in retooling their businesses and rebuilding the credit channel to help ensure a stronger, more durable economy.