[Here is a picture of Ben Bernanke explaining the theory of heavier-than-air flight while in reality the plane is being kept aloft by 50 balloons]
Well, it is not a dramatic as that, the Fed has been keeping watch all along, but with the housing market in full meltdown mode, the Fed needed to act. The problem was that the traditional solution - keep credit cheap and inject liquidity into the market - is not particularly effective when it is banks that won't deal with each other. So they take some non-traditional approaches starting with the Bear Stearns 'bailout' where they guaranteed a bunch of potentially toxic debt in return for JP Morgan Chase to buy the company for pennies on the dollar.
Then the Fed started offering non-traditional lending facilities culminating in the Term Securities Lending Facility (TSLF) which accepted AAA rated debt as collateral. Essentially allowing banks to trade potentially bad AAA debt for Treasuries - solidifying their balance sheets and making banks more comfortable in lending to each other again.
And banks have been using these new windows a lot, here is a look at the Fed's balance sheet. Note especially the area shaded in black, that is the TSLF. What this means is the Fed is now on the hook for some potentially bad bets made by the banks. Is this worth it? Well, if the other option is to see a global credit collapse, I think so. I think in the current climate, concerns over moral hazard are second-order, especially when we are experiencing other economic pressures like high energy costs.
Are the Fed's efforts working. There was some concern for quite a while but here is a statistic that has become quite popular, thanks to Paul Krugman. This is the TED Spread or the difference between the LIBOR and the 3-month Treasury rate. The LIBOR is the London Interbank Offered Rate and can be thought of as the rate banks charge each other for credit. This will go up if banks think other banks are risky borrowers. The 3-month Treasury is about as safe as you get. So if the TED Spread is high, that means banks are weary of lending to each other and is a measure of the amount that internal credit markets have seized. There was a lot of worry in March and April that the Fed's actions were not working (see below), but just recently there is very clear evidence that the internal credit crunch is easing.
So what next? Given inflationary concerns, the Fed has probably done all it can and all it will do for a while. Don't expect the Fed Funds rate to go down anytime soon and expect that it may start to creep up.
I will not go into too much detail about future actions that might be appropriate as it is not the point of this talk, but I will say that since this crisis has significant spill-over effects it is not unreasonable to consider new regulations for the securities industry, new rules for credit rating agencies and help for home buyers. I think we have yet to see the bottom of the housing market so waiting it out is not an attractive option. And the fiscal stimulus that has just be paid out I don't expect to have much effect. If I were to guess I think we are in for 3 to 4 more quarters of very slow growth, though I would be surprised if it were negative.