From today's speech:
As market participants have adjusted to what has been a very acute change in expectations about economic and credit risk, they have become more cautious in how they use their liquidity and capital. The symptoms of this are apparent in the high risk premia across a range of assets.... Elevated term premia in the interbank market has the effect of tightening overall financial conditions, offsetting some of the impact of reductions in the target federal funds rate.Translation: There'll be no more talk of the Fed going to neutral until these liquidity and credit issues have been dealt with, and confidence in the interbank lending market has returned.
The danger this poses is the risk of an adverse, self-reinforcing dynamic in which concerns about overall liquidity magnify concerns about credit problems. As financial institutions prepare for a more challenging funding environment, in part by conserving capital, and as they anticipate the higher potential losses that would normally accompany an economic slowdown, their response, in aggregate, makes markets and the economy potentially more vulnerable to that adverse outcome. The risk is a greater contraction in the availability of credit beyond what might have otherwise occurred, with attendant risks to growth.
Monetary policy has an important role to play in addressing these dynamics in markets. By adjusting policy proactively as the risk to the outlook changes, central banks can help reduce the probability of the extreme adverse outcome. And this can positively affect the incentives that might otherwise lead market participants to protect themselves against the extreme outcome.
If the Term Auction Facility doesn't revive confidence in the interbank market (and I don't think it will), the hawkish regional Fed presidents are just going to have to grin-and-bear-it and do the one and probably only thing that will revive confidence: continue cutting rates until bank balance sheets start looking healthy again.