In my view, the most likely story line is one involving a moderate slowdown in economic activity over the coming quarters, with a return to growth near trend by late 2008 as the housing sector begins to recover. Underpinning this story is the view that our modern market economy has a keen ability to self-correct as opportunistic capital moves into depressed markets. Markets correct. And market solutions are preferable. This transition already is happening in the market for subprime mortgages. In this story, financial markets may endure some more weeks or months of volatility, but I believe they will find a restructured state of "normality," involving improved risk management practices, reduced leverage, and greater transparency.

An appropriate public policy posture is to be supportive of market solutions in the financial markets.

The consequences of the liquidity shock of 2007 on the financial markets and the real economy are still playing out in real time. It is premature to delineate lessons learned with complete assurance. The facts, nonetheless, can perhaps be placed in some narrative context, drawing on the experience of prior bouts of financial instability. History, of course, is far from a perfect teacher. After all, history does not repeat itself; it only appears to do so. In that regard, the causes and consequences of market turmoil are still insufficiently understood for the end of history to be declared

On the lender side, the originate-to-distribute model can leave lenders with weaker incentives to maintain strong underwriting standards. In particular, originators who securitize may inadequately screen potential borrowers unless investors provide oversight and insist on practices that align originator incentives with the underlying risk. The originate-to-distribute system is thus not only a potential source of risk to the financial system but also raises concerns regarding consumer protection.

[T]he Federal Reserve has a responsibility to take monetary policy actions to minimize the damage that financial instability can do to the economy.  I hope I was clear in communicating to you that policies to achieve this goal are designed to help Main Street and not to bail out Wall Street.  Pursuing such policies does help financial markets recover from episodes of financial instability, and so it can help lift asset prices.  But this does not mean that market participants who have been overly optimistic about their assessment of risk don't pay a high price for their mistakes.  They have, and that is exactly what should happen in a well-functioning economy--which, after all, is what the Federal Reserve is seeking to promote. 

I noted a moment ago that periods of financial instability are characterized by valuation risk and macroeconomic risk. Monetary policy cannot have much influence on the former, but it can certainly address the latter--macroeconomic risk. By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop. The resulting reduction in uncertainty can then make it easier for the markets to collect the information that enables price discovery and to hasten the return to normal market functioning. To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible. Quick action is important for a central bank once it realizes that an episode of financial instability has the potential to set off a perverse sequence of events that pose a threat to its core objectives. Waiting too long to ease policy in such a situation would only risk a further deterioration in macroeconomic conditions and thus would arguably only increase the amount of easing that would eventually be needed.

The Federal Reserve's actions to ease the liquidity strains in financial markets were similar to actions that central banks have taken many times in the past. Promoting financial stability and the orderly functioning of financial markets is a key function of central banks. Indeed, a principal motivation for the founding of the Federal Reserve nearly a century ago was the expectation that it would reduce the incidence of financial crises by providing liquidity as needed.

The recent problems in financial and credit markets reflect a pulling back from what I would call surrogate securitization, whereby investors were willing to buy debt that had been assigned high credit ratings by the credit rating agencies, regardless of the underlying assets used in the securitization. In other words, investors basically delegated due diligence to the rating agencies. Utilizing ratings to help evaluate the riskiness of securities is a normal part of the securitization process. But when new securities arise, investors may need to exercise more caution as rating agencies themselves learn about the appropriate risk to attach to the new instruments.

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.

The past two months have been quite unusual for financial markets. Short-term liquidity has been disrupted for almost two months, as investors have reevaluated the securitization process. I am hopeful that with appropriate underwriting, the securitization process and the ABCP [asset-backed commercial paper] will continue to be a source of financing for a wide range of assets.

The Fed has three main responsibilities that pertain to these developments: promoting financial stability to help financial markets function in an orderly way, supervising and regulating banks and bank holding companies to ensure the safety and soundness of the banking system, and conducting monetary policy to achieve its congressionally mandated goals of price stability and maximum sustainable output and employment.

Although this episode of financial turmoil is still unfolding, my preliminary judgment is that there are no new lessons. Weak underwriting practices put far too many borrowers into unsuitable mortgages. As borrowers default, they suffer the consequences of foreclosure and loss of whatever equity they had in their homes. It is painful to have to move, especially under such forced circumstances. Investors are suffering heavy losses. There is no new lesson here: Sound mortgage underwriting should always be based on analysis of the borrower’s capacity to repay and not on the assumption that a bad loan can be recovered through foreclosure without loss because of rising property values.

The other aspect of the current financial turmoil that reaffirms an old lesson is that it is risky to finance long-term assets with short-term liabilities.

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.

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.    

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.  

The scientific principle that financial frictions matter to economic fluctuations has led to increased attention at central banks to concerns about financial stability. Many central banks now publish so-called Financial Stability reports, which examine vulnerabilities to the financial system that could have negative consequences for economic activity in the future.