“That was a borderline decision” after “weaker data came in,” Bullard said today on Bloomberg Television’s “Bloomberg Surveillance” with Tom Keene and Sara Eisen. “The committee came down on the side of, ‘Let’s wait.’”

Bullard called October a “live meeting,” because “it’s possible you could get some data that change the complexion of the outlook and could make the committee be comfortable with a small taper in October.”

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“I’m a little dismayed at those in markets that are saying they’re surprised by this,” Bullard said. The Fed said that, “if the economy was going to improve in the second half of the year, and if we saw that improvement, we would taper.”

... I think it enhanced our credibility in the sense that it showed we really are paying attention to data and not on some automated program to cut QE to zero.

In my view, we are unlikely to see much benefit to growth or to employment from further asset purchases. If I am right, then conveying the idea that such action will have a substantive impact on labor markets and the speed of the recovery risks the Fed’s credibility. This is quite costly: If the public loses confidence in the central bank, our ability to set effective monetary policy in the future will be harmed and households and businesses will feel the consequences.

“From a policy perspective, the assumption that a central bank can always and everywhere credibly commit to its policy rule is, I believe, also questionable,” Plosser said at a conference sponsored by Germany’s Bundesbank and the Philadelphia Fed.

“In practice, I seek ways to make policy more systematic and more credible,” Plosser said. Still, “commitment is a luxury few central bankers ever actually have, and fewer still faithfully follow.”

I believe that the FOMC’s ultimate effectiveness relies critically on its communication and the credibility of that communication. I’ve dissented at the last two meetings because I believe that the Committee’s decisions at those meetings diminish that requisite credibility.

In response to [improvement] in economic conditions, the Committee should have lowered the level of monetary accommodation over the course of the [past] year. Instead, through actions taken at its last two meetings, the Committee has raised the level of monetary accommodation. In this sense, the Committee’s recent actions in 2011 are inconsistent with the evolution of the economic data in 2011.

Economic theory and historical experience tell us that a central bank’s ability to maintain price stability and promote economic growth hinges on its credibility. Actions that undermine credibility can put at risk the effectiveness of a central bank’s ability to achieve its objectives. In my view, the actions taken in August and September risk undermining the Fed’s credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery. It is my assessment that they will not. We should not take actions simply because we can.

In my view, the actions taken in August and September tend to undermine the Fed’s credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery. It is my assessment that they will not. We should not take certain actions simply because we can.

When we do things that don't have much effect...we are undermining the credibility of the institution.

Were deflationary expectations to materialize — and let me repeat, I do not see much risk of this — I would support appropriate steps to raise expectations of inflation, including, perhaps, aggressive asset purchases coupled with clear communication that our goal is to combat deflationary expectations. But for such a strategy to be successful, the public must believe that the Fed can and will act to combat those expectations. The Fed must be credible. Protecting that credibility is why, based on my current outlook, I do not support further asset purchases of any size at this time. As I said earlier, asset purchases in our current economic environment can do little if anything to speed up the return to full employment. But if the public believes that they can and is disappointed, it may have less confidence that the Fed will act to raise inflationary expectations if needed. Because I see little gain at this point, and some costs, I would prefer not to engage in further asset purchases at this time.

I can be reasonably certain of only one point: My economic forecast is highly likely to be wrong--but I don't know how. One implication of this pervasive uncertainty is that any statement about the future path of monetary policy must be conditional--dependent on the economy following the expected path. Although the FOMC has stated that the federal funds rate is likely to remain exceptionally low for an extended period, this statement explicitly depends on an economic outlook similar to the one I have given today. We cannot provide a precise timetable for when short-term interest rates will begin to return to normal because that depends on the evolution of actual and projected activity and inflation.

One implication of this pervasive uncertainty is that any statement about the future path of monetary policy must be conditional--dependent on the economy following the expected path. Although the FOMC has stated that the federal funds rate is likely to remain exceptionally low for an extended period, this statement explicitly depends on an economic outlook similar to the one I have given today. We cannot provide a precise timetable for when short-term interest rates will begin to return to normal because that depends on the evolution of actual and projected activity and inflation.

In my experience, these and other considerations put a premium on flexibility. The need to learn from and respond to news means that policy should have a substantial discretionary component. We have certainly needed to innovate over the past several years to contain the damage from unprecedented events in financial markets. But discretion has its limits as well. We must be able to explain and justify our actions within a coherent framework--even if the elements of that framework are adjusted from time to time as experience dictates. And to the extent that we can act predictably, households and businesses will be able to anticipate our actions, reinforcing their effects. Finally, we must not be flexible about our objectives. The goals of monetary policy--price stability and maximum employment--are stable and well known. The flexibility relates to the actions we take to get there.

Sales present an unusual challenge for the Federal Reserve, because they require us to be able to make a particular kind of credible commitment. To understand this commitment, I think that it’s useful for me to talk through a situation that I see as roughly analogous.

Suppose Sarah owns two houses on the same block. Sarah decides that she wants to sell both houses. How should Sarah accomplish this change?

Clearly, if Sarah tries to sell both of her houses at once, she’s going to suffer some serious losses. The houses are on the same block, and so they end up competing with each other. Sarah needs to sell the houses slowly over time, so that they don’t compete with each other. Obviously, how slowly would depend on the particulars of market conditions. In my neighborhood right now, selling one house per year would be about the right speed.

So suppose Sarah puts one house on the market and tells everyone that she’s not going to sell the other one until a year later. Then, she sells the first house after a month. It sells at a high price, because the buyers don’t want to wait a whole year to get a house on this particular block.

At this stage, Sarah is supposed to wait a year to sell her second house. But Sarah was only planning to wait so long to sell the second house to protect the first house from competition. Once the first house is sold at a high price, she has no reason to wait. She will not fulfill her promise to wait a year.

Now think about what Sarah’s inability to wait means for her first sale. The potential buyers of the first house will all realize that they won’t have to wait a year to get a house on the same block. They will not be willing to pay a high price for the first house. And so Sarah’s lack of credibility means that the first house will necessarily sell at the same price as if she’s actually selling both houses at the same time.

The Federal Reserve faces exactly these same problems when undertaking to sell MBSs. Like Sarah, if the Federal Reserve were to sell its holdings of MBSs all at once, the sales price of the MBSs would be low. Long-term interest rates would spike up, which the Federal Reserve doesn’t want. Like Sarah, the Federal Reserve can avoid this problem by spacing its sales out over time. But just like Sarah, the Federal Reserve faces a commitment problem. The Federal Reserve wants to sell gradually in large part to ensure that its early sales of MBSs are at a high price. But once those early sales are made, the Federal Reserve has an increased incentive to sell its remaining MBSs rapidly. And as in Sarah’s case, if the market believes that the Federal Reserve will act on this increased incentive, the Federal Reserve will only be able to sell its early MBSs at a low price. Under this story, any MBS sales—no matter how small—may have big effects on long-term interest rates.

So far, sales sound pretty challenging! Fortunately, the analogy between the Federal Reserve and Sarah is incomplete. The difference gets at the very heart of what the Federal Reserve is about. Our structure—and in particular our independence from Congress and the president—means that we are set up to act in the public’s long-run interest, not to maximize short-run political or monetary gain. This structure means that, with the right set of policymakers on the FOMC, the Federal Reserve can credibly make and keep long-run commitments. Indeed, our credibility has been critical in the past crisis. Since July 2007, the monetary base has more than doubled, and the public debt has gone up by over 30 percent. At the same time, though, long-run inflationary expectations—as embedded in the prices of 5-year and 10-year inflation-indexed TIPS bonds—have moved slightly, if at all. The public and markets trust the Federal Reserve to keep inflation under control—and we will fulfill their trust.

Our structure means too that the Federal Reserve can credibly commit to selling its MBSs slowly over time. Along these lines, in testimony before Congress in late March, Chairman Bernanke described how he expected MBS sales to work. He emphasized that the timing of initiating sales, like any other move by the FOMC, would depend on its assessment of economic conditions. But once conditions are right, he suggested that the Federal Reserve could reduce its balance sheet by pre-announcing and then implementing a slow, gradual path of sales.

The Fed's greatest asset is its institutional credibility. This institutional credibility is rooted in its inflation-fighting credibility, but it is broader still. It is tied up in the full range of Fed actions and balance sheet commitments. This credibility is essential. It increases the heft of our communications. It gives weight to our economic assessments. It amplifies the effect of announced changes in the short-term policy rate on longer-term rates. It is, in some sense, the real money multiplier in the conduct of policy.

If one examines the inflation record of the United States, and of many other industrial economies for that matter, since the early 1980s, it appears that central banks have largely succeeded in delivering diminishing and, ultimately, low inflation. I can think of no reason why this cannot continue.

I do believe, however, that lender-of-last resort policies should take a lesson from what we have learned from the theory of monetary policy. In particular, policy should have important rule-like features. Specifying in advance the conditions or states of the world under which the central bank will lend is an essential first step. But policy must also make credible commitments to act in a systematic way consistent with explicit ex-ante guidelines. Discretion in lending practices runs the risk of exacerbating moral hazard and encouraging financial institutions to take excessive amounts of risk. Nevertheless, the issue of trading off financial stability and moral hazard will likely remain. 

Beyond that, the central bank's historical role as a lender of last resort places it squarely in the center of financial disruptions as they unfold. We are perhaps not as close to a consensus on the proper conduct of this role as we are with regard to price stability. But as we continue to learn about the causes and nature of financial instability, I believe we should strive for policy that is informed by the lessons learned in the achievement of price stability. Chief among those is that a central bank can achieve better outcomes if it can establish credibility for a pattern of behavior consistent with achieving its long-term goals.

The Fed has worked hard for 30 years to develop credibility with the public that we will deliver on low and stable inflation. That credibility is hard to earn, but easy to lose if you’re not careful.