Consider where this analysis leaves us...  The central bank can hold its policy rate relatively steady and rely on market adjustments in long rates to do much of the stabilization work... The current situation is a perfect illustration. The Fed doesn’t know and market participants do not know either, the full implications of last week’s stock market declines and increases in risk spreads. Market reactions last week may be overdone, or perhaps not. We just do not know. In a situation like the terrorist attacks of 9/11, the Fed knew enough to believe that a quick policy response would be helpful and unlikely to itself be destabilizing.

A typical market upset, such as last week’s, is not at all like 9/11. Most of these upsets stabilize on their own, but some do not. I’m not saying that the Fed should ignore what happened last week—we need to understand what is happening. However, it is important that the Fed not permit uncertainty over policy to add to the existing uncertainty. The market understands, I believe, that the Fed will act in due time, if and when evidence accumulates that action would be appropriate. That is why trading in the federal funds futures market reflects changed odds from two weeks ago on a policy adjustment later this year...

The regularity of Fed behavior I espouse is that the Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment, or when financial-market developments threaten market processes themselves... [E]ffects on the economy can rarely be understood without passage of time and more information. Occasionally, there is contemporaneous evidence of damage to market mechanisms that might justify quick Fed action.

In recent months, many market participants have expressed concern that a widening of credit spreads from relatively narrow levels could lead to hedge fund losses that would make funds unwilling or unable to maintain their existing positions, thus potentially eroding market liquidity. Such circumstances could pose significant challenges to hedge funds' counterparties and creditors and perhaps to other market participants. Thus far, however, the repricing of credit risk does not appear to have imposed significant strains on the financial system.

During a financial crisis, risk aversion rises dramatically, and deliberate trading strategies are replaced by rising fear-induced disengagement from market activity. It is the general human experience that when confronted with uncertainty, whether in financial markets or in any other aspect of life, disengagement is the normal protective reaction. In markets that are net long, the most general case, disengagement brings falling prices. In the more extreme manifestation, the inability or unwillingness to differentiate among degrees of risk drives trading strategies to seek ever-more-liquid instruments that presumably would permit investors immediately to reverse decisions at minimum cost should that be required. As a consequence, even among riskless assets, such as U.S. Treasury securities, liquidity premiums rise sharply as investors seek the heavily traded "on-the-run" issues--a behavior that was so evident in the fall of 1998.