WINKLER: Five-year bond yields suggested for expected inflation have turned positive for the first time in more than three years. Is the Fed ready to accept this tightening of financial conditions?

DUDLEY: Well I think we evaluate what the economic outlook is and what's happening to financial conditions. And obviously we don't control financial conditions. It also depends on what's happening in the global economy. But we definitely take that on board. I think when I - the dollar it has appreciated a bit over the last few months, not by a significantly (inaudible), but obviously that does factor in terms of our economic forecast. If the dollar were to strengthen a lot it would have consequences for growth. We would have poorer trade performance, less exports, more imports. And if the dollar were to appreciate a lot it would tend to dampen inflation. So it would make it harder to achieve our two objectives. So obviously we would take that into account.

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I think that the dollar partly reflects the relative performance of the U.S. economy relative to performances in other countries, and in that case that you could sort of understand what we're seeing. I think from our perspective we don't care about the dollar per se. In other words that's not a goal, independent goal of policy. Our goal policy is maximum sustainable employment and two percent inflation. Obviously as the dollar moves that affects the appropriateness of a given monetary policy to achieve those objectives. And we certainly take it on board just like we take on board what's happening to the stock market, what's happening to the bond market, what's happening to credit spreads, what's happening to credit availability. All those factors sort of drive our assessment of what's happening to financial conditions. And then that influences our economic outlook. And then that in turn then influences the monetary policy response.

[I]f monetary policy waits until it is certain that the labor market has fully recovered before beginning to raise rates, policy will be far behind the curve. One risk of waiting is that the Committee may be forced to raise rates very quickly to prevent an increase in inflation. In so doing, this may create unnecessary volatility and a rapid tightening of financial conditions — either of which could be disruptive to the economy.

This would represent a return of the so-called "go-stop" policies of the past. Such language was used to describe episodes when the Fed was viewed as providing lots of accommodation to stimulate employment and the economy — the go phase — only to find itself forced to apply the brakes abruptly to prevent a rapid uptick in inflation — the stop phase. This approach to policy led to more volatility and was more disruptive than many found desirable.

For these reasons, I would prefer that we start to raise rates sooner rather than later. This may allow us to increase rates more gradually as the data improve rather than face the prospect of a more abrupt increase in rates to catch up with market forces, which could be the outcome of a prolonged delay in our willingness to act.

In addition, given the uncertainties surrounding our forecasts of the pace of labor market improvement and the degree of remaining slack, monetary policy has to be determined largely by incoming data and the signals that data provide about the health of labor markets. If the economy disappoints we should be in no rush to raise short-term rates, but if the economy improves more quickly than anticipated we should raise short term rates earlier. Thus, we should be moving away from providing date-based forward guidance, and instead focus on what incoming data tell us about reaching full employment and 2 percent inflation within a reasonable time period.

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In fact, I actually hold the view that as we approach levels of unemployment that many consider “full employment,” the Fed should no longer issue guidance on the approximate timing of any monetary policy changes.

I do not intend this to reduce transparency in monetary policymaking. Rather, I simply want to acknowledge that any reference to calendar dates has the potential to be inaccurate. The date of “liftoff” from near-zero short-term rates is highly dependent on how the economy actually evolves – in other words, is going to be tied to the current and expected path of inflation and employment. We are getting close enough to targets that, given the uncertainty around forecasts of these variables, incoming data that cause Federal Reserve policymakers to significantly change our outlook for the economy will shift any expected lift-off date forward or backward in time. So, again, reference to calendar dates as we approach targets has the potential to be inaccurate.

If one assumes that the unemployment rate will continue to fall at the same pace in 2016 as it is expected to fall in 2015, both forecasts would reach the Boston Fed’s 5.25 percent estimate of full employment around the middle of 2016. As I’ve said on many occasions, I personally do not expect that it will be appropriate to raise short-term rates until the U.S. economy is within one year of both achieving full employment and returning to within a narrow band around 2 percent inflation. Again, that is my personal view. And, if one were to also assume that tightening would begin roughly one year before reaching full employment and the 2 percent inflation target, then one could say that the primary dealers’ estimates of a rate rise bunched around mid-2015 seem roughly consistent with the forecasts for unemployment in Figure 2.

Yet the labor market’s journey is not yet complete – more progress needs to be made. My outlook is that as the expansion continues, firms will continue to add to their payrolls and the unemployment rate will continue to decline. I expect that by the end of next year, the unemployment rate will fall to around 5½ percent, which is what I view as the “natural rate,” or longer-run rate, of unemployment.

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Putting all of this together, I expect growth over the next six quarters to be somewhat above my estimate of trend growth, which I put at around 2.5 percent. Of course, there is always a good deal of uncertainty around estimates of trend growth, perhaps even more so today in the aftermath of such a deep recession. I am a bit more optimistic than some about longer-run growth because while productivity growth has been running low, I think it is good to remember the experience of the 1990s. Back then, over a period of several years, many forecasters revised down trend growth estimates only to subsequently revise them up significantly in response to strong productivity growth.

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One might ask whether that’s a reasonable inflation forecast given that we haven’t seen much acceleration in wages yet. I believe it is. Cleveland Fed analysis, based on several measures of wages and broader compensation, indicates that it is difficult to find a lead-lag relationship between wages and prices – the strongest correlations are contemporaneous ones, especially since the mid-1980s. We should expect wages to rise with prices, not necessarily lead prices. In my view, it would not be prudent for policymakers to simply wait for wages to accelerate before assessing the implications of the stance of monetary policy for future price inflation. Indeed, policymakers must always be forward looking.

...[M]onetary policy ultimately must be conducted in a pragmatic manner that relies not on any particular indicator or model, but instead reflects an ongoing assessment of a wide range of information in the context of our ever-evolving understanding of the economy.

"The market is trading too dovishly compared to the committee,” Bullard said today in an interview on SiriusXM satellite radio. “I think that’s probably a mistake,” he said, adding that market participants “should come closer to where the median of the committee is.”

Bullard said he projects the FOMC will announce the first rate increase since 2006 at the end of the first quarter of 2015, while noting his forecast is “probably on the early side” of those of his colleagues on the committee.

“The case for the end of the first quarter next year is improving because labor markets have improved a lot,” he said.

"You hear a lot of concerns that it is time for us to exit, time for us to start thinking about leaving the zero lower bound and raising rates," Kocherlakota told community bankers here. "But boy, it's a mistake to go too early. And we should profit from the examples of other countries on that."

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"As long as inflation remains low, below 2 percent, below our target, we have room to be supportive and to be helpful," Kocherlakota told the Independent Community Bankers of Minnesota, citing research from his bank that increasing inflation by a quarter of a percentage point could add 1 million jobs to the American economy. The FOMC is still a long way from meeting its targeted goal of price stability.

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Kocherlakota started his job in 2009 as a policy hawk, but abandoned that stance after the inflationary threat he thought he saw looming never materialized. "You get beaten in the head with the numbers enough and you have to change your mind, and that's what I have done," he said.

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Citing the "disturbingly low" fraction of people aged 25 to 54 who actually have a job, and the historically high fraction of part-time workers who would prefer to work full time, Kocherlakota said he believes labor markets are still "some way from meeting the (Fed)'s goal of full employment."

“The idea that the Fed might get behind the curve is a powerful one, and that’s certainly been the history of the institution. People are right to worry about that,” Mr. Bullard said.

Mr. Bullard said he did not share the sentiment of some of his colleagues, expressed in the Fed statement after its July meeting, that its benchmark rate may need to remain historically low “even after employment and inflation are near mandate-consistent levels.”

He said he has not revised his view of the long-run fed funds rate as somewhere around 4%. For this reason, Mr. Bullard thinks the Fed may need to raise rates more quickly than some of his colleagues do. “It takes a long time to do this normalization–it’s like turning a supertanker in the ocean,” Mr. Bullard said. “Waiting too long might get us into trouble.”

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“The end of the first quarter of 2015 is still my preferred liftoff date” for raising the fed-funds rate, Mr. Bullard said.

ASMAN: Now, there is also a charge, uh, and this one, I think, may be more on target, that the Fed is a little too concerned these days, for the past year or so, about how the markets will react to its policies. That is, there are people like Paul Volcker, who really squashed inflation by his actions back in the day. He didn't give a damn what the market felt about what needed to be done to maintain the integrity of the dollar.

Is it true that the Fed is paying too much attention to what the market is doing?

FISHER: I think there are some differences of opinion on that. I don't agree with that. I -- by the way, was trained by the same man that trained Paul Volcker. I'm very much a Volckerite. And I think what we should focus in on is the real economy.

I have argued publicly that 0 interest rates and this massive monetary accommodation, obviously, has distorted the markets. These valuations are very, very high, because the rates are so much lower because interest rates are so low. And eventually, they'll have to be an adjustment.

But, you know, the real thing is whether the real economy, putting people back to work, keeping inflation under control, propelling the economy forward toward greater prosperity, that's what I worry about.

And I am less worried about the money changers and whether or not we're going to disappoint some of them. As long as it doesn't lead to crippling the economy...

My own assessment {in December 2013} was that the economy would gradually recover. I projected that by the fourth quarter of 2014 the unemployment rate would decline to 6.2 percent, and year-over-year PCE inflation would rise to 1.8 percent. Consistent with that view of gradual economic recovery, I believed that an appropriate monetary policy would require the funds rate to rise to 1.25 percent by year-end 2014.

With the economy having already reached my year-end 2014 forecast for inflation and unemployment, and appearing to be well on its way toward achieving my 2015 forecasts approximately a year ahead of schedule, the funds rate setting remains well behind what I consider to be appropriate given our goals.

Short-term interest-rate markets have for months priced in a slower tempo of increases than policy makers themselves forecast. Thats risky because the misalignment, a bet against a rate path that the central bank alone controls, could lead to volatility if traders have to adjust rapidly, Lacker said.

When there is that kind of gap, it gets your attention, Lacker, a consistent critic of the Feds record easing who votes on policy next year, said in an Aug. 1 interview at his Richmond office overlooking the James River. It wouldnt be good for it to be closed with great rapidity.

Investors may also be giving too much credence to a phrase in the Feds statement that even after employment and inflation are close to its goals, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.

They may be placing more weight on that than I think it deserves, said Lacker, who dissented against his colleagues at every meeting of the FOMC in 2012. They may think we have more conviction about that than we do.

I feel personally that we are closer to liftoff than we were, people felt we were, the market assumed we were, some time late in 2015... At the last meeting, I felt, as I listened to the discussion at the table, that my views were being digested by more and more participants.

One has to bear in mind that monetary policy has to lead economic developments. Monetary policy is a bit like duck hunting. If you want to bag a mallard, you dont aim where the bird is at present, you aim ahead of its flight pattern. To me, the flight pattern of the economy is clearly toward increasing employment and inflation that will sooner than expected pierce through the tolerance level of 2 percent.

Some economists have argued that we should accept overshooting our 2 percent inflation target if it results in a lower unemployment rate. Or a more fulsome one as measured by participation in the employment pool or the duration of unemployment. They submit that we can always tighten policy ex post to bring down inflation once this has occurred.

I would remind them that Junes unemployment rate of 6.1 percent was not a result of a fall in the participation rate and that the median duration of unemployment has been declining. I would remind them, also, that monetary policy is unable to erase structural unemployment caused by skills mismatches or educational shortfalls. More critically, I would remind them of the asymmetry of the economic risks around full employment. The notion that we can always tighten if it turns out that the economy is stronger than we thought it would be or that weve overshot full employment is dangerous. Tightening monetary policy once we have pushed past sustainable capacity limits has almost always resulted in recession, the last thing we need in the aftermath of the crisis we have just suffered.

We have in the past seen sort of false dawns, periods in which we thought our growth would speed, pick up and the labor market would improve more quickly. And later events have proven those hopes to be -- to be, unfortunately, over-optimistic. So we are watching very carefully, especially when short-term, overnight rates are at zero, so we have no ability to lower them further.

We need to be careful to make sure that the economy is on a solid trajectory before we consider raising interest rates. And I think the forward guidance that we have provided and the policies we have -- we have put in place are providing a great deal of accommodation to the economy to make sure that it is on a sound trajectory.