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The financial dimensionThe financial dimension of the current contraction has brought a historic expansion in government lending to financial market participants, mostly through an expanding array of Federal Reserve (Fed) initiatives. This contrasts with the Fed's typical response to recent recessions that has been limited to adjustments of the target Fed funds rate. Restrictions on credit supply and declines of creditworthiness have both contributed to the contraction in lending, although the latter cause has probably been underestimated relative to the former. Fed and other government lending programs have targeted particular sectors, altering the allocation of credit across markets. Also, targeted credit programs contribute to the moral hazard problem inherent in the provision of government-funded credit or guarantees. An alternative approach to monetary policy where the Fed funds target is essentially zero is purchasing Treasuries, which is likely to have little effect on the relative credit spreads on different financial instruments. However, given that targeted lending has taken place, it is critical that regulatory mechanisms be installed so that government regulation matches the scope of government support. Also, targeted lending by the Fed is in effect fiscal policy. Is this a legitimate role for a central bank, or should such lending be subject to legislative approval, with the Fed's role limited to monetary stability?

The U.S. economy is now in the second year of a recession that began at the end of 2007. The deterioration in economic activity has been particularly sharp since September 2008. But, throughout this downturn, a singular feature has been the extent of the disruption to financial markets and losses suffered by financial institutions. The financial dimension of this contraction has brought a historic expansion in government lending to financial market participants, mostly through an expanding array of Federal Reserve (Fed) initiatives. In contrast, the Fed's response to most recessions in recent decades has been limited to adjustments of the target Fed funds rate. We have done that in this cycle, too, bringing the target of funds rate from 5 1/4 percent in September of 2007 to between 0 and 25 basis points as of early March 2009.