[C]entral bank credibility is vital, it's hard to earn, costly to lose. Credibility depends critically on the confidence we engender that we will keep inflation low. But credibility is more complicated than that. It depends on the confidence we engender in our capacity to understand the forces operating on our economy. It depends on how, not just whether, we achieve price stability.

Credibility is not, however, one-dimensional. Sustained low inflation is desired for its own sake but even more for the contribution it makes to high employment and economic growth. Thus, while inflation damages credibility, so also can high unemployment. There is a fine balance here. We know that monetary policy cannot affect employment in the long run, but we also know that monetary policy mistakes can create unemployment over an uncomfortably long short run. When unemployment rises, policymakers need to be able to explain in credible fashion why the problem is not a consequence of a monetary policy mistake, for that perception is always present among some observers in such circumstances. There is, after all, some historical justification for such a perception given that almost all economists agree that monetary policy mistakes contributed to the severity of the Great Depression. Given the importance of high employment, a period of sustained excessive unemployment may create doubts about future policy, and this uncertainty is a manifestation of impaired credibility.

I would expect us to be within the {comfort} zone within a couple of years.  We are a little above the top of the zone now and my own personal expectation is, inflation is moderating, and we will get down to the zone...

To bring inflation down very, very rapidly in a narrow timeframe of a year or two can require swings in monetary policy that can be damaging to the economy.  So there is a trade-off. 

It is always an important consideration to make sure our credibility is intact and that inflation expectations remain well contained.

In response to the question:  "Are you worried that the Fed could lose its inflation-fighting credibility?"

I'm very concerned.  And it's not a big black or white thing, losing our credibility.  I think that everyone believes we wouldn't let the '70s happen again.  But an erosion from 1.5%, to let inflation, core inflation, drift from 1.5% up to 3%, I'm not sure people are convinced we wouldn't let that happen, and I think we ought to take action to prevent that notion from becoming lodged in peoples' minds.

On the risk of the Fed losing credibility:  Of course there's always a risk. But we watch pretty carefully and we don't want to see that risk materialize. Certainly as long as I have anything to do with this process I will be pushing hard for a policy that is as tight as it has to be, as disciplined as it has to be, to keep long-run inflation within bounds. And that would be lower than today's inflation.

{Our response} depends on what we know about why {inflation is} hanging high, if that's the hypothesis we're exploring. We need to look at why and we need to look at the various lags in this system.

If we believe that we're headed off in the right direction then we can be patient. We can be patient and sit there and not create a disturbance in the economy. 

I have often noted that my own personal preference is to define “price stability” as a condition in which the rate of inflation, properly measured, is on average zero. I insert the qualifier “properly measured” to point out that actual price indexes may have statistical problems such that zero measured inflation on a particular price index might not in fact reflect a true state of zero inflation. Although my own preference is for zero inflation properly measured, I believe that a central bank consensus on some other numerical goal of reasonably low inflation is more important than the exact number chosen. Thus, I find that recent discussion of a “comfort zone” of 1-2 percent inflation measured by the price index for personal consumption expenditures, excluding the volatile food and energy components, is perfectly consistent with my own thinking.

In practice, financial market participants and the public in general cannot adequately understand the Fed’s monetary policy—that is the strategic thinking that guides the sequence of individual policy actions—without a good understanding of what the FOMC considers to be an acceptable long-run average rate of inflation. When monetary policymakers articulate their goal for long-run inflation and pursue credible policies to achieve that goal, they provide the basis for “anchoring” the inflation expectations that guide consumption behavior of households and investment decisions of firms. Inflation expectations also determine the inflation premiums in nominal interest rates that are required to bring financial markets into balance...

It is a terrible thing if monetary policy makers lose credibility that they will maintain low and stable long-run inflation. Once credibility is impaired, it can only be reestablished the “old fashioned way”—policymakers have to earn it! Restoring credibility takes time in the face of substantial persistence in the actual inflation process. It took well over a decade to completely restore low inflation in the United States after the Great Inflation of the 1970s, and in the process the economy experienced the worst recession, 1981-82, since the Great Depression.

Moreover, a systematic, consistent approach helps build the public's confidence in the Fed's commitment to low and stable inflation; this confidence, in turn, may well make it easier for the Fed to respond to fluctuations in labor and product markets, because there is less risk that an easing of policy will unleash a wave of inflation fears.

Central bank credibility is an aspect of the broader issue of trust. Credibility and trust, once lost, can be extremely expensive to regain. I believe that most policymakers recognize this fact, and the recognition has much to do with efforts to enhance transparency to build trust.

During the 1970s, inflation expectations were very poorly anchored. There was very little confidence that the Fed would keep inflation low and stable. When oil prices rose, those price increases fed through quickly into other prices and began to raise the general rate of inflation quite quickly.

The Fed responded somewhat in a panicked way by raising interest rates enormously, which then contributed to the deep recessions of 1975 and 1981-'82.

In a more recent episode, we've had extensive increases in energy prices, but outside of the energy sector, if you look at core inflation, core inflation remains very well controlled. And as a result, the Fed Reserve has been able to raise interest rates from its low accommodative level, but to only 4 percent at this point. And the economy is growing strongly.

So I think this is an enormously good illustration of why keeping inflation low, stable and keeping expectations well-anchored is of tremendous benefit, not just on the inflation side, but also on the employment and growth side.

From the Q&A session

Given the persistence of high energy prices that the global economy has confronted of late, policymakers cannot be complacent. Central bankers must reinforce their credibility and validate the confidence of market participants by actively leaning against inflationary pressures long before inflation itself builds. Again, the FOMC has done just that through its commitment to adjust policy as required to keep inflation at bay.

The Fed’s inflation-fighting credibility may be somewhat more fragile over the next few years than it has been over the past few years.

It is difficult to explain what has happened to [long-term interest] rates.  I think the credibility of monetary policy is an aspect.

To mitigate the risks [resulting from large fiscal and current account deficits]...we can work to keep monetary policy credible, to preserve confidence we will act to keep inflation and inflation expectations stable at moderate levels.

The future path will be conditional on future information that cannot itself be predicted. Attempts to provide specific forward-looking guidance will prove inaccurate and even misleading to the market. Moreover, the Fed could create a credibility problem for itself if forward guidance is too specific.