[I]t bears noting that some survey measures of longer-term inflation expectations have moved a little lower over the past couple of years, while proxies for these expectations inferred from financial market instruments like inflation-protected securities have moved down more noticeably. It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.

We do monitor inflation expectations very carefully. If we saw in a meaningful way that inflation expectations were either moving up in a way that made them seen unanchored, or down, that would be of concern.  And we have called attention to some slight downward movements and survey measures. We are watching that. But I still judge that inflation expectations are reasonably well anchored.

In the first instance, as already noted, core inflation can to some extent be influenced by oil prices. However, a larger effect comes from changes in the exchange value of the dollar, and the rise in the dollar over the past year is an important reason inflation has remained low.
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The dynamics with which all these factors affect inflation depend crucially on the behavior of inflation expectations. One striking feature of the economic environment is that longer-term inflation expectations in the United States appear to have remained generally stable since the late 1990s. The source of that stability is open to debate, but the fact that the Fed has kept inflation relatively low and stable for three decades must be an important part of the explanation. Expectations that are not stable, but instead follow actual inflation up or down, would allow inflation to drift persistently.
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We should however be cautious in our assessment that inflation expectations are remaining stable. One reason is that measures of inflation compensation in the market for Treasury securities have moved down somewhat since last summer. But these movements can be hard to interpret, as at times they may reflect factors other than inflation expectations, such as changes in demand for the unparalleled liquidity of nominal Treasury securities.

Making monetary policy is sometimes compared to driving a car, with policymakers pressing on the accelerator or the brakes, depending on whether the economy needs to be sped up or slowed down at that moment. That analogy is imperfect, however, for at least two reasons. First, the main effects of monetary policy actions on the economy are not felt immediately but instead play out over quarters or even years. Hence, unlike the driver of a car, monetary policymakers cannot simply respond to what lies immediately in front of them but must try to look well ahead--admittedly, a difficult task. Second, the effects of monetary policy on the economy today depend importantly not only on current policy actions, but also on the public's expectations of how policy will evolve. The automotive analogy clearly breaks down here, for it is as if the current speed of the car depended on what the car itself expects the driver to do in the future.

“I have been surprised by the stability of inflation and inflation expectations.”

“Given the expansion of our balance sheet, if you told me we were heading to a $4 trillion balance sheet, $4 trillion of outside money in the system, and that inflation expectations have remained stable, and apparently as a result inflation itself has remained remarkably stable, I wouldn’t have put 99% probability on that. I would have put much less probability on that,” Mr. Lacker said in response to audience questions.

Since the 3-month Treasury rate has remained very close to zero for more than four years, the movements in the real rate must primarily reflect changes in the other part of the equation – the inflation rate. Importantly, as the inflation rate falls, the real interest rate rises. Higher real interest rates make it more expensive to borrow, after controlling for changes in inflation. Japan has been an extreme example of this dynamic, given that deflation has caused the real interest rate to remain positive despite a weak economy and falling prices.

In sum, the longer we in the U.S. remain so far below our 2 percent target, the greater the risk that inflation expectations could fall and real interest rates rise. In part to offset this risk, the Fed has conducted large-scale asset purchases that increase its balance sheet.

I want to be clear about the economic mechanism by which the proposed liftoff plan generates stimulus. First, it does not generate stimulus by having the FOMC tolerate higher rates of inflation, as has been espoused by many observers. I am doubtful about the efficacy of the inflation-based approach. I suspect that many households would believe that their wage increases would not keep up with the higher anticipated inflation rates. Those households would save more and spend less—exactly the opposite of the policy’s aim. In any event, I think that this approach is a risky one for central banks to use, because it requires them to raise inflation expectations—but not too much.

Whether the increase in gasoline prices, and energy prices more broadly, turns into a persistent inflation problem depends critically on the evolution of inflation expectations. Last year, as actual inflation accelerated and decelerated, survey measures and financial market indicators of inflation expectations remained relatively stable, which limited the influence of the price shocks we saw a year ago. If, as I expect, inflation expectations remain stable in response to the recent run-up in gasoline prices, their influence on overall inflation should be limited as well.

In particular, the Committees actions in 2011 suggest that it is now more willing to tolerate higher-than-target inflation than it was in 2009. If this possible drift in inflation tolerance were to persist, or were expected to persist, it could give rise to a damaging increase in inflationary expectations.

I dissented from this change in language because the evolution of macroeconomic data did not reflect a need to make monetary policy more accommodative than in November 2010. In particular, personal consumption expenditure (PCE) inflation rose notably in the first half of 2011, whether or not one includes food and energy. At the same time, while unemployment does remain disturbingly high, it has fallen since November.

I can summarize my reasoning as follows. I believe that in November, the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.

Going forward, my votes on monetary policy will continue to be based on the evolution of the data on PCE inflation and its components, medium-term PCE inflation expectations, and unemployment.

Expectations are well-anchored until they are not. So it is somewhat troubling to me that expectations of inflation in the medium to longer term are moving up and down as much as they are. It suggests that the public and the markets may not have as much confidence in the Fed’s ability, or willingness, to deliver on its price stability mandate.

One caveat that would cause Evans to “reassess my inflation outlook” would be if “medium term inflationary expectations were to rise,” he said.

“If inflation expectations were to start to creep up because of rising commodity prices or any other factor, the FOMC would consider this important development and act accordingly to keep inflation expectations well grounded,” he said.

[O]ne of the key things that we'll be looking at will be inflation expectations, because if medium-term inflation expectations remain well anchored and stable, so that firms at not passing on, at least on an ongoing sustained basis, these higher costs into broader prices and creating a broader inflation in the economy, as long as inflation expectations are well -- well stabilized, that won't happen. Then we'll feel more comfortable just watching and waiting and seeing how things evolve.

[I]t is clear that we cannot be complacent about the stability of inflation expectations, and we must be prepared to take decisive action to keep these expectations stable. For example, if a continued run-up in commodity prices appeared to be sparking a wage-price spiral, then underlying inflation could begin trending upward at an unacceptable pace. Such circumstances would clearly call for policy firming to ensure that longer-term inflation expectations remain firmly anchored.

[L]ke my colleagues on the FOMC, I continuously monitor performance against our price stability objective. This involves monitoring not just inflation today but importantly the course of inflation expectations, whether derived from surveys or pulled from financial market prices. I am prepared to support a change of policy if evidence accumulates that the low and stable inflation objective is at risk.