Inflation is currently measured at lower-than-desired rates. A few months ago, fear of deflation was justified, but recently this concern has abated and the rate of inflation seems to have stabilized. Concern about inflation is rising because of higher gasoline prices and higher commodity prices, including food commodities. We are hearing stories that businesses incurring higher input costs may try to pass them through to retail prices. Higher input costs have not, however, translated to broad inflation of consumer goods and services. And, importantly, longer-term inflation expectations have stabilized in a healthy range. Through 2011 and 2012, I expect gradual firming of underlying inflation pressures from current very low levels to healthier levels.

Some even worry that the economy might fall into a deflationary trap. I am not one of them.

We are also conscious of a potential adverse feedback loop between persistent economic weakness and a continuing decline in inflation and inflation expectations...  Indeed, if such a process continued for some time, we could fall into deflation, much as Japan did for a time in the 1990s and earlier this decade. Then again, the substantial increase in the size of the Federal Reserve's balance sheet as a result of the credit programs that have been implemented have led some to worry that inflation could rise sharply when the economy recovers unless the Federal Reserve moves quickly when the time comes to unwind the programs and limit the growth in credit.

My last speech here in Columbus was in June of last year, to a group of bankers... Given the spike in oil and commodity prices at that time, we were also keeping a vigilant eye on what seemed to be a potential rise in inflation. A lot has changed in nine short months. The economy has worsened significantly, and we are now concerned about an unwelcome disinflation.

Should lingering financial turmoil continue to weigh on the economy and stretch the recession out still longer, the zero or negative inflation could continue through 2009. Over that time frame, deflationary expectations could become entrenched. For this reason I think we face some risk—at this point only a risk—of sustained deflation. One important near-term goal for monetary policy is to guide the economy away from this outcome.

From a speech entitled "Dial M for Monetary Policy"

[W]hile the monetary base has expanded at an extraordinarily fast pace during the fall and winter, much of that expansion has been closely related to the Fed’s lender-of-last-resort function, and cannot be counted on to keep expectations of disinflation and deflation at bay. Because of this, the Fed needs a more systematic method of keeping the persistent component of monetary base growth rates elevated in order to combat the risk of a deflationary trap.

…

“As I have discussed, the Fed’s balance sheet has grown at an astounding rate since September of last year, and the monetary base has more than doubled. But the new, temporary, lender-of-last-resort programs are blurring the meaning of this picture. A temporary increase in the monetary base, by itself, would not normally be considered inflationary. The increase would have to be expected to be sustained in the future in order to have an impact. Much, but not all, of the recent increase in the balance sheet can reasonably be viewed as temporary. The outright purchases of agency debt and MBS are likely to be more persistent, however, and it is these purchases that may provide enough expansion in the monetary base to offset the risk of further disinflation and possible deflation. The quantitative effects of policy actions in this new environment are more uncertain than normal, but nevertheless these less-conventional policies can have every bit as powerful an impact on the economy as changes in the intended federal funds rate.

There was a real serious concern about deflation. If you look at the notes of the Open Market Committee, the pressures were to go lower than 1 percent. There were no dissents. The only dissents were that we should go lower. People don't remember that period. [People thought there was] a threat to American stability because it looked as though we were replicating much of what Japan had done when it had fallen into a corrosive deflation.

Our forecast at the time said the chances were low, but the consequences to the country would have been so great that taking out insurance was by far the most sensible policy. I still believe that today.

On the decision to keep the federal funds rate at 1 percent from mid-2003 to mid-2004
 

The last item on my list of limitations was that simple rules do not take account of risk-management considerations.  As shown in Figure 2A, the core CPI inflation rate for 2003 was falling toward 1 percent.  The real-time reading of the core PCE inflation rate (not shown) was on average even lower than the comparable CPI figure.  Given these rates, the possibility of deflation could not be ruled out.  We had carefully analyzed the Japanese experience of the early 1990s; our conclusion was that aggressively moving against the risk of deflation would pay dividends by reducing the odds on needing to deal with the zero bound on nominal interest rates should the economy be hit with another negative shock.  This factor is not captured by simple policy rules.

Nonetheless, during my tenure at the Fed, the FOMC has had to react to a number of important and difficult challenges: the Asian financial crisis, the Russian debt default, major movements in asset prices, the acceleration in productivity, Y2K, 9/11, and the risk of deflation. All of these issues generated policy questions that did not fit neatly into any familiar textbook framework. They exemplify how, when making tough decisions in unusual circumstances, it's important to follow sound policy-making principles:

• Look at a wide range of data and information, instead of one or two summary indicators;
• Use cogent economic theory to shape analysis;
• And respect the risks of undesirable outcomes for growth or inflation, even in environments that appear benign.

It used to be thought that the dual mandate required the Fed to temper pursuit of its inflation goal from time to time in the interest of minimizing disturbances to employment. That view began to change 40 years ago. Over time, the mainstream view in the economics profession has increasingly emphasized the importance of price stability for achieving maximum employment and maximum sustainable economic growth. I myself have become passionate about price stability. It is important to remember that the two greatest employment disasters in U.S. history were the Great Depression and the Great Inflation. Deflation from late 1929 to 1933 drove the U.S. economy down and down, and the unemployment rate rose to 25 percent. During the Great Inflation, from 1965 to 1981, the United States suffered four recessions, the last of which in 1981-82 drove the unemployment rate to a peak of 10.7 percent at the end of 1982, the highest since the Great Depression.

Experience abroad confirms the connection between price instability and unemployment. For one example, Japan suffered a decade of deflation in the 1990s; economic growth was minimal and unemployment rose.

Of course, gradualism and model averaging may not be appropriate in all circumstances.  For example, it may be necessary for monetary policy to respond to what might be called "tail events," along the lines suggested by recent work on "robust control."  To simplify greatly, this approach often amounts to choosing policy settings to minimize the maximum possible loss across different models of the economy, in contrast to the standard Bayesian approach, which (loosely speaking) seeks to minimize the average loss across models.  Much of the research on robust control has been a bit technical and esoteric.  But the notion that policymakers may at times base policy settings on especially pernicious risks has an important ring of truth. 

For example, in 2003 the FOMC noted that a continued fall in inflation would be unwelcome largely because such an eventuality might potentially lead to persistently weak real activity with interest rates stuck at zero.  Partly in response, the FOMC reduced the federal funds rate to an unusually low level and kept it there for an extended period, in a manner that perhaps would not have occurred in the absence of concerns about the "worst case" effects of deflation.  This type of risk management--in which the central bank takes out some insurance against a bad but improbable event--has been an aspect of policymaking for some time and does seem to respond to extreme risks in a way reminiscent of the literature on robust control.

Rather than demonstrating the need for preemptive extra action to restrain emerging bubbles, these examples [of the Great Depression and the recent Japanese deflation experience] are object lessons concerning the wisdom of central banks' easing promptly and aggressively following market slumps when inflation is already low, so as to head off the threat posed by the zero lower bound. By doing so, policymakers should be able to avoid the severe nonlinear dynamics of deflation.

The economic world in which we function is best described by a structure whose parameters are continuously changing. The channels of monetary policy, consequently, are changing in tandem. An ongoing challenge for the Federal Reserve--indeed, for any central bank--is to operate in a way that does not depend on a fixed economic structure based on historically average coefficients...

Moreover, we recognize that the simple linear functions underlying most of our econometric structures may not hold outside the range in which adequate economic observations exist. For example, it is difficult to have much confidence in the ability of models fit to the data of the moderate inflations of the postwar period to accurately predict what the behavior of the economy would be in an environment of aggregate price deflation.

Before the 1980s, research papers, economic commentary, and textbooks here and abroad were full of discussions of the causes and consequences of high inflation and of the political difficulty of bringing it under control. It looked then like inflation had become a more or less permanent feature of the economic landscape. Concepts associated with deflation such as liquidity traps and the zero bound on nominal interest rates had, for practical purposes, disappeared from economic thought.

Today I would like to share my own thoughts on the prospect of an "unwelcome substantial fall in inflation"--in particular, why a substantial fall in inflation going forward would indeed be unwelcome; why some risk of further disinflation, though "minor," should not be ignored; and what such a fall would imply for the conduct of monetary policy...

Let's first be clear what we are talking about. Some in the media apparently interpreted the May 6 statement as saying that the Federal Reserve anticipated imminent deflation in the United States and informed the public accordingly. In my view, such an interpretation substantially overstates the concerns that the FOMC intended to communicate with its statement. First, we have no reason to think that a drastic change in the inflation rate is imminent...

This distinction between inflation that is positive yet too low and deflation is worth exploring for a moment. Although the Federal Reserve does not have an explicit numerical target range for measured inflation, FOMC behavior and rhetoric have suggested to many observers that the Committee does have an implicit preferred range for inflation. Most relevant here, the bottom of that preferred range clearly seems to be a value greater than zero measured inflation, at least 1 percent per year or so.