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

I'm sure there'll be some other instrument that the market chooses to challenge. This is part of what I've described in the past as the price discovery process ... I'm guessing it will still be bumpy for a while to come.

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

There is no analogy in financial markets to macroeconomic price stability. The prices of financial products may change quite substantially when new information arrives. Indeed, one of the most important activities of financial markets is price discovery—the efficient assimilation of all available information into asset values. This promotes the appropriate allocation of capital among competing demands and supports maximum sustainable growth. And it is this efficient functioning of markets that is our concern with regard to financial stability.

[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.

I would characterize the current state of affected financial markets (those most affected by the subprime problem) as evolving positively but still fragile—in other words, unusually vulnerable to shocks. Affected markets are working through problems of counterparty mistrust, lower or no trading volume, reduced new origination, and plummeting market prices that may be well below eventual economic value. For instance, investors have been reluctant to roll over asset-backed commercial paper because of the linkages to subprime mortgage–backed securities purchased by structured investment vehicles, or SIVs. The asset-backed commercial paper (ABCP) market has shrunk over $400 billion since August of last year, and major investors have exited, possibly permanently.

Earlier in the week I had a briefing on the pandemic flu risk. And this morning I was at the Carter Center hearing about the eradication of the guinea worm, and here we are at lunch talking about subprime lending. All relate to contagion... I guess it's the theme of the week.

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

As has been true of many financial innovations in the past, the benefits of this disaggregated originate-to-distribute model may have been obvious, but the problems less so.  ... Originators had every incentive to maintain origination volume, because that would allow them to earn substantial fees, but they had weak incentives to maintain loan quality.  When loans went bad, originators lost money, mainly because of the warranties they provided on loans; however, those warranties often expired as quickly as ninety days after origination.  Furthermore, unlike traditional players in mortgage markets, originators often saw little value in their charters, because they often had little capital tied up in their firm.  When hit with a wave of early payment defaults and the associated warranty claims, they simply went out of business.  While the lending boom lasted, however, originators earned large profits.  

"The markets are not healed, but I believe a lot of progress has been made," Poole said in an interview with Bloomberg Television. "You see a lot of the spreads narrowing, for example, the term Libor is more or less back to normal."

"A lot of banks and others are raising capital. We see the monoline insurance industry raising capital, getting things straightened out there. It's coming along."

As reported by Reuters.

Financial disruptions have an important impact in terms of lending, and they actually have an impact in terms of spending ... These issues are something that we have to pay attention to and have been paying a lot of attention to.

From Q&A as reported by Reuters 

Obviously, there are some challenges in the economy right now and of course we're looking at that very, very carefully. I think it's very valuable that some of the concerns about the monoline insurers are being addressed by market participants.

From Q&A as reported by Reuters

The Term Auction Facility is a useful new part of the Fed's tool kit that should stick around as long as it's needed, he said.

"I do think it had a psychological impact. I also think it had a real impact," Fisher said. "It more specifically addresses the hardening of the arteries in the cardiovascular system of money, as opposed to being a tool to be used for the purposes that we use federal funds rate for."

From press Q&A as reported by Market News International

As for the municipal bonds, Fisher said that market's woes do not appear to be having a significant liquidity impact on corporate financing. So far, corporate treasurers and cash managers aren't overly dependent on those instruments in their portfolio, he said. But it's a different story for the muni market itself.

"There's a short-term impact. I think the long-term impact of that will be mitigated by new financing methods that'll be discovered by issuers," Fisher said.

From press Q&A as reported by Market News International

The financial disruption is going to be handled in due time by the banks raising more capital and resuming the normal process of lending. That is taking place. I don't know how long it's going to take for it to be complete.

From audience Q&A, on the subprime mortgage crisis and related market turmoil. As reported by Market News International

I think the Federal Reserve has taken appropriate policy steps to respond to a financial shock, a shock that may well produce parallels to the headwinds episode of the early 1990s. In this environment, we need to remain sensitive to evolving financial conditions and to incoming information on business activity in order to further determine the relevance of that earlier experience. And the aftermath of that episode may also prove relevant, in that it illustrates the underlying resilience of the American economy and the value of policy adherence to the dual mandate.

And while I think the term “debt overhang” is overly broad, a significant number of homeowners are experiencing considerable strain. Finally, in view of my earlier comments about impaired markets and institutions, the possibility of a credit crunch, and its attendant effects on economic performance, cannot be ruled out.

To my knowledge, there is not a precise definition of a credit crunch, but I would describe it as an environment in which quality borrowers find credit either unavailable or available only on very expensive terms. To the extent that such a situation develops, its economic impact is that some investment projects and planned spending will be deferred or delayed for a time because of the difficulty of obtaining financing, resulting in more modest economic growth than would otherwise occur.

These issues are clearly weighing on policy. While such an environment will not be permanent, it could well persist for an extended period because, if credit is in fact restricted by some institutions and in some markets, it will likely take time for potential borrowers to find alternatives and substitutes.