As I mentioned earlier, I think inflation will stabilize and begin to move back in the direction of the FOMC's 2 percent objective as the economy gathers momentum. So I'm interpreting the soft inflation numbers as a risk signal. Through the lens of prices, the economy could be weaker than we currently believe. I talk with a lot of business people across the Southeast. Very few claim to have much pricing power. At the same time, inflation expectationsmeasured by surveys and inflation-adjusted financial instrumentshave remained stable. There are no signs of disinflationary expectations being priced in. This gives me some confidence that inflation will firm.

I'm uncertain about what's going to happen to the economic outlook over the near term because I don't really understand really well how the tug-of-war between the fiscal drag and the improving economy are going to sort of work their way out over the next couple months. I think three or four months from now I think you're going to have a much better sense of is the economy healthy enough to overcome the fiscal drag or not.

…

It's something that I certainly have my eye on, but I'm not very nervous about the fact that inflation's come in a little low relative to our 2 percent target because inflation expectations are still well-anchored. If inflation expectations were coming down, then I'd be a lot more concerned. If inflation expectations are well-anchored, what that means is inflation expectations are higher than the current rate of inflation, and so that'll tend to pull inflation back upwards a little bit.

Well, I think QE is [an option] but at this point I think it should only be deployed if the economy deteriorates significantly. We've already got a very easy policy on the table. We're already taking a lot of risk with that balance sheet and I think the economic news and the economic data could indicate that it's been surprising to the upside so I think we're in a situation where we should keep QE3 in reserve.

I think [the criterion for QE] is much more of a deflation side as I think it is - one thing about QE2 is that inflation was running at a very low rate in the fall of 2010. We did turn that around and now inflation is running higher - I think PC headline was about 4.2 percent - as measured from a year earlier, in the fall of 2010. Now it's running 2.4 percent or so, as measured from a year earlier. So, it's quite a significant move up in inflation and so I do think it does help us on that dimension.

Fisher, who has criticized the Fed’s asset purchase program and expressed concern about rising prices, said the central bank has “successfully fought off” deflation.

“There is a lot of liquidity in the system,” Fisher said.

"Even though we have achieved liftoff, we are by no means rocketing to the moon," he said. While current economic growth rates are "respectable and improving," he said, the recession slashed output so deeply that it still has a long way to go.

As reported by Reuters

The economist said he's not concerned with "too much inflation, but rather too little".

As reported by Bloomberg News

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.

The downward trend in inflation during the recession had many commentators warning of the possibility of outright deflation. At this point, I think the risk of deflation is negligible.

I am leaning in favor of additional monetary stimulus while acknowledging the longer-term risks the policy may present. At this juncture, and given the circumstances of sluggish growth and measured inflation that is too low, I give greater weight to the risk of further disinflation leading to deflation. In my mind, QE2 is a form of risk management—an insurance policy that is prudent to put in place at this time.

...[A] small precautionary action to avoid any risk associated with inadvertent tightening was prudent, in my view, in the midst of disappointing economic indicators.

That is how I interpret the decision announced following the August meeting—a small tactical change designed to preserve the level of liquidity provided to the system. I supported the committee's decision, but I do not view it as a fundamental change of outlook or strategy. I do not believe this change necessarily heralds the beginning of a period of further expansion of the Fed's balance sheet. Nor do I think the decision precludes a return to a policy of allowing the balance sheet to shrink on its own.

I think the decision has been over-interpreted in some quarters. These interpretations, along with alarmist commentary about deflation and a double-dip recession, are feeding an exaggerated sense of foreboding.

Despite the weaker data seen recently, the preconditions for a pickup in growth in 2011 appear to remain in place. Monetary policy remains very accommodative, and financial conditions have become more supportive of growth, in part because a concerted effort by policymakers in Europe has reduced fears related to sovereign debts and the banking system there...

Although output growth should be stronger next year, resource slack and unemployment seem likely to decline only slowly. The prospect of high unemployment for a long period of time remains a central concern of policy. Not only does high unemployment, particularly long-term unemployment, impose heavy costs on the unemployed and their families and on society, but it also poses risks to the sustainability of the recovery itself through its effects on households' incomes and confidence...

Maintaining price stability is also a central concern of policy. Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee's objectives.

It is conventional for central banks to attribute deflationary outcomes to temporary shortfalls in aggregate demand. Given that interpretation, central banks then respond to deflation by easing monetary policy in order to generate extra demand. Unfortunately, this conventional response leads to problems if followed for too long. The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

"If inflation expectations don’t fall significantly, I don’t see how deflation is a big risk,” Lacker told reporters yesterday after a speech in Norfolk, Virginia. “The stability of inflation expectations is going to exert a gravitational pull."

Given the amount of substantial excess capacity that we have in the economy, there is some risk of further disinflation. And I would say the risk of deflation has gone up and is more of a risk than I would like to see at this point.

 Recent evidence I am seeing puts momentum on the side of disinflation, at least in the short run.

Because of the enormous slack in the system, and as you know I tend to be very vigilant about inflation, we’re just not seeing price pressures right now. If anything, the tail risks are on the deflationary side.