My intent today is not to suggest that the Federal Reserve is somehow omniscient regarding the path of the U.S. economy. Nor is it my intent to suggest that the Federal Reserve's knowledge and tools are sufficiently surgical to steer the U.S. economy completely unscathed through the choppy waters of financial market turbulence. And of course, I do not literally mean to suggest that common aphorisms provide an infallible compass to guide the economy past shocks of one sort or another. Instead, my goal is to describe the Federal Reserve's monetary responsibilities, highlight the critical role of liquidity in financial markets, and discuss the recent financial market turmoil. While the subprime-mortgage markets showed some of the earliest and most pronounced indications of weakness, I believe that problems afflicting the subprime-mortgage markets served more as the trigger than the fundamental cause of recent market turmoil and economic uncertainty.
Monetary responsibilities and financial markets
By way of background, allow me to highlight the Federal Reserve's dual mandate for monetary policy, as embodied in the Federal Reserve Act. The Federal Reserve's statutory objectives are to institute policies that foster maximum employment and price stability. To ensure that these objectives are consistent with each other and with strong, enduring economic performance over time, my colleagues, past and present, interpret "maximum employment" to mean maximum sustainable employment. In pursuing this objective, the Federal Reserve is trying to foster an environment in which those who are looking for work can reasonably find it. Similarly, we generally interpret our congressional mandate to ensure "price stability" to mean that inflation (the rate of price change for a broad range of products and services) is at sufficiently low and predictable levels so that it is not a factor in the economic planning of households and businesses.
The principal instruments of monetary policy conducted by the Federal Reserve – open market operations, the discount rate, and reserve requirements – do not operate in a vacuum.3 Rather, they operate dynamically in association with ever-changing financial market conditions to produce effects on the real economy. Indeed, well-functioning financial markets are a precondition for a sustainable, prosperous economy.
Financial markets facilitate the flow of capital from individuals and institutions that have savings to individuals and institutions with investment opportunities that are deemed worthwhile. When functioning properly, financial markets may also lower financing costs by allocating risks to suppliers of capital most willing and able to bear them. Investments that build human and physical capital, in turn, generate economic growth and ultimately raise living standards. In addition, financial markets should serve as a shock absorber of sorts for both individuals and businesses. The capital cushions of financial intermediaries, for example, should help mitigate the impact of financial shocks on the overall economy.
Conversely, when financial markets function poorly, the capital allocation process I just described is impaired, and worthwhile investment projects may go unfunded. In the extreme, savers refuse to part with their funds for capital investments at virtually any price. Instead, they retreat to the shore for safety, waiting for calmer seas and cooler heads to prevail. As I have noted previously, "While policymakers and market participants know with certainty that these episodes will occur, [we] must be humble in [our] ability to predict the timing, scope, and duration of these periods of financial distress." 4
A fuller description of the tools available to Federal Reserve policymakers is in Laurence H. Meyer (1998), "Come with Me to the FOMC," Gillis Lecture, speech delivered at Williamette University, Salem, Ore., April 2, www.federalreserve.gov/newsevents.
Kevin Warsh (2007), "Market Liquidity: Definitions and Implications," speech delivered at the Institute of
BIS Review 104/2007