I did not hear a great deal of opposition to the principle that the Federal Reserve at times should help markets function when they are in a state of panic or otherwise in serious dysfunction. So in that respect, I think that this is the kind of tool that under some circumstances might prove quite useful.

In discussing a staff proposal for a term auction credit facility and activation of foreign central bank swap lines in response to the liquidity crisis.

My guess is that a great deal of the potential dislocation resulting from corrective reactions to the subprime boom will be resolved by regulatory initiatives rather than by monetary policy...

Any new regulations that might now be crafted to prevent future recurrences must be well thought out, for two reasons. First, financial institutions will quickly adapt to defeat any regulation that is poorly designed, morphing into new, vaccine-resistant strains. Second, heavy-handed regulations are sometimes worse than the disease against which they are meant to protect. I would be wary of any regulatory initiatives that interfere with market discipline and attempts to protect risk takers from the consequences of bad decisions for fear of creating a moral hazard that might endanger the long-term health of our economic and financial system simply to provide momentary relief.  

In determining the appropriate course for monetary policy, we must recognize that most of the data available now reflect conditions before the disruptions began and, therefore, tell us less about the appropriate stance of policy than they normally would. In addition to data lags, appropriate policy decisions must also, I believe, entail consideration of the role of policy lags--that is, the lag between a policy action and its impact on the economy. Addressing these policy complications requires not only careful and vigilant monitoring of financial market developments, but also the formation of judgments about how these developments will affect employment, output, and inflation. In other words, I believe it is critical to take a forward-looking approach—gauging the effects of recent developments on the outlook, and, importantly, the risks to that outlook.  

A change in monetary policy would be required if the outlook for the economy changes in a way that is inconsistent with the Fed’s goals of price stability and maximum sustainable economic growth. Certainly, standing here today, it is obvious that tighter credit conditions and disruptions in financial markets have increased the uncertainty surrounding our forecasts of the economy. The FOMC continues to monitor incoming data and other economic information for signs that these disruptions are having a broader impact on the economy. In my view, it will be very important to assess such information in light of the Fed’s commitment to achieving its long-run goals of price stability and sustainable economic growth.

Fortunately, legislative and regulatory changes in the U.S. over the past several decades have allowed banks and other financial firms to diversify their portfolios of assets and their geographic boundaries. Institutions that make mortgage loans no longer are limited to taking deposits within limited geographic areas. They no longer are restricted as to what interest rate they can pay on those deposits. And they no longer are prevented from making other types of loans. In addition, financial innovations, such as asset securitization, have allowed the spreading of risks in the financial system. This means that today banks and many other financial institutions are much better diversified than during previous housing cycles. Thus, both deregulation of the financial system and innovations in financial products have lessened the risk of asset price declines triggering substantial adverse effects in the financial sector. 

My first principle is let markets work.  The second principle is the central bank has a responsibility to promote orderly conditions in financial markets, stepping in as necessary to avoid severe system disruption.  The third principle is to make sure the second principle doesn't undermine our long-term mission.

There are certainly tensions to be resolved in applying these principles, and formulating measured responses to circumstances requires good judgment, particularly in transitional periods.  I believe we are in such a period now.

As a final thought, I counsel policymakers and market participants alike to remember that no two crises are the same.  Recall that the Asian crisis of 1997-98 actually manifested itself differently across Asian countries, with each country having its own set of problems and needing to find its own solutions.  In other words, there is never a single remedy to each crisis and each brings its own surprises and risks.  Clearly, we can all learn a lot from past crises--which is the value in holding conferences like this one.  But we should not assume that past remedies will fully solve the next set of problems or address all future risks.  The key is to take lessons from the past and tailor them appropriately to future situations of potential distress.

It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions.  But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.

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Well-functioning financial markets are essential for a prosperous economy… The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets...

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The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

Financial market volatility, in and of itself, does not require a change in the target federal funds rate, in my view. Interest rate policy needs to be guided by the outlook for real spending and inflation. Financial turbulence has the potential to change the assessment of the appropriate rate if it induces a sufficient revision in growth or inflation prospects.

Some estimates are in the order of between $50 billion and $100 billion of losses associated with subprime credit products. The credit rating agencies have begun to try to make sure they account for those losses, and they have downgraded some of these products.  I should say that the investors, many of them recognize that even before the downgrades occurred that there were risks associated with these products, including not only credit risks, but also liquidity and interest rate, other types of risks.

And in private equity in particular, [private pools of capital and hedge funds] play an important role in the market for corporate control. We need to have a mechanism whereby poorly run companies, weak managements are subject to being taken over, replaced and their companies improved. And when it's working right, at least, private equity -- as LBOs in the past -- helps to serve that function. So they do serve some positive functions.  

They raise many issues of financial stability and the like, you know, making sure that their counterparties are taking appropriate attention to their risks and the like. And we've discussed those some in the president's working groups' principles. But they certainly are a benefit to the economy.  

In the Q&A session

The Federal Reserve's supervision of counterparty risk management practices is part of a broader, more comprehensive set of supervisory initiatives. The goal of these initiatives is to assess whether global banks' risk-management practices and financial market infrastructures are sufficiently robust to cope with stresses that could accompany a deterioration of market conditions, including a deterioration that might result from the rapid liquidation of hedge funds' positions.

The Board believes that the increased scale and scope of hedge funds has brought significant net benefits to financial markets. Indeed, hedge funds have the potential to reduce systemic risk by dispersing risks more broadly and by serving as a large pool of opportunistic capital that can stabilize financial markets in the event of disturbances. At the same time, the recent growth of hedge funds presents some formidable challenges to the achievement of public policy objectives, including significant risk-management challenges to market participants. If market participants prove unwilling or unable to meet these challenges, losses in the hedge fund sector could pose significant risks to financial stability.

The Board believes that the "Principles and Guidelines Regarding Private Pools of Capital" issued by the President's Working Group on Financial Markets (PWG) in February provides a sound framework for addressing these challenges associated with hedge funds, including the potential for systemic risk.¹ The Board shares the considered judgment of the PWG: the most effective mechanism for limiting systemic risks from hedge funds is market discipline; and, the most important providers of market discipline are the large, global commercial and investment banks that are their principal creditors and counterparties.

There are good reasons to think that financial innovation over the past few decades, including the emergence and growth of the credit derivatives markets, has made the financial system and the economy more resilient. But it would be foolish to think that these innovations have eliminated systemic risk.