Fed Vice Chairman Bolsters Rate-Cut Hopes

"In general, I think those dual objectives -- promoting financial stability and avoiding the creation of moral hazard -- are best reconciled by central banks' focusing on the macroeconomic objectives of price stability and maximum employment," he continued.

Kohn conceded that cutting rates to keep the economy intact when the financial markets are suffering will likely reduce the penalty incurred by certain investors who made bad bets. "But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson," he said.

Because of the mess in the market for mortgage-backed securities, some of Wall Street's biggest banks have taken billions of dollars in writedowns, and there's little doubt more are on the way.

Kohn said "the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses."

He also noted that the heightened worries about added losses at financial firms have hurt equity prices "and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses, as well."