Taking all of this into consideration, our outlook at the Chicago Fed is for weakness in real GDP this year, particularly in the first half of the year. However, we think conditions will improve in the second half of the year.

A number of factors will likely hold back activity for some time. The strains on credit intermediation and financial balance sheets mean that credit conditions will likely restrict spending. The large overhang of unsold homes will continue to restrain residential investment. Greater caution on the part of businesses and consumers will likely limit increases in their discretionary expenditures as well. Because financial issues are being worked out against the backdrop of a soft economy, we also have to recognize the risk that interactions between the two might reinforce the weakness in the economy.

Nonetheless, other factors point to improvement later in the year. We have lowered the federal funds rate by 300 basis points since September. At 2.25 percent, the current federal funds rate is accommodative and should support stronger growth. Indeed, because monetary policy works with a lag, the effects of last fall's rate cuts are probably just beginning to be felt, and the cumulative declines should do more to promote growth going forward.

The effects of the fiscal stimulus bill also are likely to boost spending in the second and third quarters of 2008.

Together these policy actions expand our role by providing liquidity in exchange for sound but less liquid securities. These policy innovations share important features of increasing both the term and the quantity of our lending and making additional quantities of highly liquid Treasury securities available to financial intermediaries. This is intended to reduce uncertainty among financial institutions and allow them to meet the liquidity needs of their clients.

While these policy actions represent major innovations in practice, they are in the spirit of the oldest traditions of central banking. As described by Walter Bagehot in his 1873 treatise Lombard Street, the job of the central bank is to "lend freely, against good collateral" whenever there is a shortage of liquidity in markets.

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

I agree that the Fed certainly cannot afford to take for granted that inflation expectations will remain well-anchored.

At the same time, there are downside inflationary pressures relating to the slowdown in the U.S. economy. ... [T]he U.S. economy is particularly exposed to downside risks from the unwinding of the housing bubble and disruptions in financial markets. There is some slack now in the U.S. labor market and, if these downside economic risks materialize, quite a bit more slack could emerge. Even with a flatter Phillips curve, such a development would place some downward pressure on inflation. It is this unpleasant combination of risks to both inflation and employment that the FOMC must balance as it assesses the appropriate path for monetary policy going forward.

I think it is very important ... for central bankers to do their best in keeping a steady hand under emergency circumstance. I am not saying this is an emergency circumstance but when things are volatile, it's important that central bankers be deliberate.

As reported by Market News International

My own view is that we should consider hard-wiring more sprinkler systems into financial markets and insitutions. One obvious area to look is whether we can improve the risk-based capital approach embodied in Basel II. If capital is to function effectively, it needs to rise as risks increase and be depleted as losses materialize. I think we need to look especially at the procyclical behavior of leverage that we have observed in some large financial institutions, In addition, I believe there may be merit in considering formal liquidity requirements, and perhaps loan-to-value ratios for banks and other financial institutions, especially the large institutions that provide liquidity and risk-management products to other financial institutions and financial markets. I also think that it is time we extinguish some of the off-balance sheet fictions that have developed to excess in recent years.

When times are good, as they have been for many years and banks appear well-capitalized, it is very difficult for bank supervisors to convince bankers to heed warnings that they need to behave differently. Indeed, in many situations, there may be no legal basis for requiring a change in business or lending practices. Thus I don't think we can expect expanded supervision to prevent the types of financial excesses we have seen in recent years.

In any event, my view is that we should regard recent events in the mortgage market as reflecting the normal process of innovation. The lessons have been expensive and painful, and the pain is not yet over. As with the dot-com bust, where many firms went bankrupt but some sound business models survived, we should expect that successful innovations behind the subprime market will also survive. In time, I believe, we will find that the subprime sector of the mortgage market will be as normal as any other part of the mortgage market.

The unwinding of this global financial boom has caused a substantial degree of stress to the financial system. Was this preventable? I don’t believe that asset price and credit booms are preventable. They cannot be effectively diffused preemptively. There is no reliable early warning system for financial shocks.

First, some financial products were not well designed to withstand liquidity problems. To avoid paying banks fees to provide a liquidity backstop, many financial products of recent vintage included provisions to force liquidation when necessary to insure payment to the holders of the higher-graded securities (or slices of securities). This structure was used, for example, by structured investment vehicles (SIVs)

13. However, due to the recent financial stress, assets of SIVs could not be liquidated at prices felt to be reasonable. Broadly speaking, products should be structured to better weather periods of illiquidity, and ratings models should take better account of liquidity risk.

Securities that are consistent enough to trade on an exchange are more likely to have market prices that all participants can use.

the difficulties in obtaining market prices are likely to be significantly reduced, as are the consequent uncertainties like those we are currently facing.

We have good reason to think that current financial strains have substantially slowed the pace of economic activity.

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 think progress is being made in the financial markets. It looks very shaky everyday there is some more bad news, I don't know what's happen today other than this set of testimony and I hope that's not bad news, but I think there are some signs out there that we're working through the problem. There is greater transparency by firms with problems on their banks. There is capital coming into the system that several of my colleagues have mentioned on the panel. So people are raising capital, they are being much more open about what the issues are. I think part of this problem is about uncertainty so increased transparency by lenders and others with problems on their books is going to be very helpful to letting people know what the downside risks are, how to price them in. I do think the markets have gotten to a point that they are anticipating some pretty adverse kinds of outcomes in the housing market and in the economy to a certain extent.

From Q&A as reported by Market News International

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