On Tuesday, Fed Chairman Ben Bernanke discussed the role of central banks at a conference at the Federal Reserve Bank of Atlanta.

A sharp housing contraction has generated substantial losses on many mortgage-related assets and a broad-based tightening in credit availability. Consistent with its role as the nation’s central bank, the Federal Reserve has responded not only with an easing of monetary policy but also with a number of steps aimed at reducing funding pressures for depository institutions and primary securities dealers and at improving overall market liquidity and market functioning.

The Fed’s traditional approach to monetary policy was ill equipped to handle the strains the housing contraction caused on the financial system.  It had to initiate a number of new policies to combat the liquidity crisis that many financial institutions were facing.

Besides cutting interest rates to make the cost of credit cheaper, the Fed also reduced the spread to 25 basis points between the federal funds rate, the rate at which banks lend to each other and the discount rate, the rate at which banks borrow from the Fed.  During the current credit crisis banks have been reluctant to lend to each other due to mistrust of their counter parties solvency.

The discount window has also been opened up to non-commercial banking institutions for the first time, providing a credit backstop to investment banks.  They have also had to combat the stigma many financial institutions face that conditions are so bad that they must borrow from the discount window in the first place.

The Fed has had to pump large amounts of monetary funds into the financial system through it’s various auction facilities.  It has also increased the range of collateral it is willing to accept, basically providing a market for mortgage related securities that have grown increasingly illiquid as investor confidence has deteriorated.

While confidence in the credit markets may be slow to return, the Fed has instilled confidence with investors that the central bank will take any step necessary during times of financial stress.

The Fed’s rate slashing campaign has appeared to right the floundering financial system but nonetheless the housing slump continues to worsen. The Fed Chairman Ben Bernanke spoke before the Columbia School of Business on Monday and remarked on mortgage delinquencies and foreclosures.

“Most Americans are paying their mortgages on time and are not at risk of foreclosure. But high rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets, and the broader economy. Therefore, doing what we can to avoid preventable foreclosures is not just in the interest of lenders and borrowers. It’s in everybody’s interest.”

He also calls for an increased role for the Federal Housing Administration as well as Fannie Mae and Freddie Mac in assisting the housing market. These agencies may have to step up their efforts to provide liquidity to mortgage markets as the commercial banking system appears unwilling at the moment.

Home prices have continued to fall as private financial institutions have tightened lending standards significantly, which is having an adverse effect on housing demand. Bernanke is expecting the high rate of foreclosures to continue at least to the end of the year.

One also has to keep in mind that there could be a considerable lag from the time credit markets are fully restored to when it will have a noticeable effect on the housing market. The opposite was the case, as it took a year after home prices began to fall before financial system was rocked by sub prime write downs.

The Fed’s latest rate cut will probably be the last one it will make for some time, with two members of the open market committee dissenting in last week’s vote. I believe that they would prefer to keep interest rates at their current level for as long as possible but recently the president of the Kansas City district has called the problem of inflation “serious” and that the Fed may be prompted to raise rates.

Earlier today, the Labor Department released employment data which showed that the economy lost 20,000 jobs in the month of April, much less than the 75,000 which economists had forecasted. The Secretary of Labor issued this statement after the report was released.

“In today’s better than expected jobs report, both payroll employment and the unemployment rate were essentially unchanged from last month. While we continued to see declines in construction and manufacturing, the service-providing sector of the economy showed an encouraging increase of 90,000 jobs. The economic stimulus checks, some of which have already been mailed out, should help working families cope with the very real short term challenges of the current economy.”

The news comes as a pleasant surprise on the heels of the Fed’s rate cut on Wednesday. The impression that the Fed will keep rates at their current level for the near future has also helped in stabilizing the dollar’s free fall in currency markets, while also putting a damper on rising oil prices.

Today, the Fed also announced measures to inject more liquidity into credit markets by increasing the loan amounts for it’s Term Auction Facility to $150 billion, an increase of $50 billion from the previous month. This is in coordination with European and Swiss central banks which also announced liquidity moves, albeit at a much smaller scale.

It remains to be seen what impact the economic stimulus package will have on consumer spending and economic growth in the upcoming months but for now a relatively positive news week has left many analysts with the feeling that the economic downturn might be milder that what many people once feared.