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.

[I]nflation is now on target, as far as I'm concerned. Over the last 12 months the price index for personal consumption expenditure has risen 1.5 percent, which is exactly what I've been recommending for the last six years. We also track a core price index that omits volatile food and energy prices, and it is sending the same message, having risen by 1.4 percent over the last 12 months. I believe that the Fed's best contribution to our nation's economic prosperity over time would be to keep inflation stable near the current 1.5 percent rate. But inflation has been lower this year, with overall inflation increasing at only a 0.7 percent annual rate, which is too low for me. I would point out that these inflation numbers often run hot or cold for several months at a time, which is why economists focus on the 12-month number I cited a moment ago. I am not yet convinced that inflation is likely to remain undesirably low. Moreover, the public's expectation of future inflation is not at such a low level; indeed, the latest survey from the University of Michigan puts the public's short-run inflation expectation at 2.2 percent. So I do not see a material risk of deflation — that is, an outright decline in the price level.

[T]he current circumstances are really extraordinary. It seems to me if we could somehow get lower real interest rates so that the amount of excess savings that is taking place relative to investment needs is lowered, that would be one channel for stimulating the economy. That could be done through communication. I take our price stability mandate to be 2% inflation. We’re not at 2%. I foresee 2012 inflation as 1%. If we could indicate to the public that we want inflation to increase toward that price stability goal, that would serve to lower real interest rates given that short-term nominal interest rates are close to zero. Thinking about the fact that we’re running below our inflation objective and what it might mean to make up some part of that somewhere along the line, that would also give rise to lower real interest rates. Convincing the public that this is what we intend to do, that could be a useful tool.

Question:  New York Fed President William Dudley talked about making up lost ground on inflation later. You support that?

Evans: That is a potentially useful policy tool at this point and I definitely think we should study that more. That comes out of the literature.

Were deflationary expectations to materialize — and let me repeat, I do not see much risk of this — I would support appropriate steps to raise expectations of inflation, including, perhaps, aggressive asset purchases coupled with clear communication that our goal is to combat deflationary expectations. But for such a strategy to be successful, the public must believe that the Fed can and will act to combat those expectations. The Fed must be credible. Protecting that credibility is why, based on my current outlook, I do not support further asset purchases of any size at this time. As I said earlier, asset purchases in our current economic environment can do little if anything to speed up the return to full employment. But if the public believes that they can and is disappointed, it may have less confidence that the Fed will act to raise inflationary expectations if needed. Because I see little gain at this point, and some costs, I would prefer not to engage in further asset purchases at this time.

Having inflation expectation anchored in this situation (zero interest rates) is really critical... Risking unanchoring of expectation would be far too risky and far too costly. No one has done it and it is understandable why.

      Well, his {Laurence Ball} argument is that at a higher inflation rate, then nominal interest rates would also be higher, on average, and that would give more space to cut during a recession, and perhaps more ability to create impetus.

      So that's not a logical argument, but it has substantial risks which are -- you know, we, the Federal Reserve, over a long period of time, has established a great deal of credibility in terms of keeping inflation low, around 2 percent, roughly speaking. And you can see that, for example, in inflation-indexed Treasury debt, which shows that people expect, over the next 10 years, about 2.2 percent inflation, on average, over that 10-year period. 

      If we were to go to 4 percent -- and, say, we're going to 4 percent, you know, we would risk, I think, losing a lot of that hard- won credibility, because folks would say, 'Well, if we go to 4, why not go to 6;' and you go to 6, 'why not go to 8?' It'd be very difficult to tie down, credibly, expectations at 4, beyond which, of course, in the longer-term low inflation is good for the economy, and 4 percent is already getting up there a bit, and would probably have detrimental effects on the functioning of our markets, and so on. 

      So I understand the argument, but that's not a way -- that's not a direction that we're interested in pursuing. We're going to keep our inflation objectives about where they are. We think about 2 percent is about appropriate, given biases and measurement of inflation, and given the need to have a little bit of space between the average inflation rate and the risk of having deflation or falling prices. So that's where we're going to be -- that's the path we're going to be following. 

Another uncertainty deserving of additional examination involves the effect of large-scale purchases of longer-term assets on expectations about monetary policy. The more we buy, the more reserves we will ultimately need to absorb and the more assets we will ultimately need to dispose of before the conduct of monetary policy, the behavior of interbank markets, and the Federal Reserve's balance sheet can return completely to normal. As a consequence, these types of purchases can increase inflation expectations among some observers who may see a risk that we will not reduce reserves and raise interest rates in a timely fashion.

Third, central banks need to be very careful in using information extracted from market data when conducting monetary policy. The anchoring of inflation expectations is a very important benchmark for assessing whether the stance of monetary policy has become too expansionary and whether there are risks of falling behind the curve. However, the pre-crisis period and the crisis itself have shown that expectations are not always formed in a rational way and might themselves be influenced by the behaviour of the monetary authorities. Quite often markets participants form their expectations by looking at central banks’ behaviour, on the assumption that the latter have better and more information about underlying inflationary pressures. Under these circumstances, market-based inflation forecasts tend to be biased and may react in a perverse way following a tightening of monetary policy. In particular, inflation expectations may be revised up, rather than down, after an interest rate increase, especially at the beginning of a tightening cycle. If the monetary authorities’ assumption that inflation expectations are well anchored proves to be wrong, the whole yield curve might move upwards and the decision to increase the rate of interest may result in a much sharper tightening than expected. ^[4]

Another problem with inflation expectations concerns their measurement, especially in periods of financial turbulence, when the liquidity of the underlying instruments can affect their signalling content. A further distortion may arise when the central bank is itself a major buyer and holder of indexed-linked assets, which may distort prices and thus the information content. Measurement problems arise also with other components of the analytical framework, such as the output gap. Experience shows that measurement of the output gap varies over time. For instance, when measured ex post, with the data available until 2008, the US output gap over the period 2002-2004 turned out to be very small, even non-existent, while ex ante it was estimated at around 2% of GDP. ^[5]

Editor's note:  We don't ordinarily include comments from central bankers in other countries in this database, but some comments are too insightful to pass up.

I don’t think that we have an exit problem. I think that we’re going to be able to manage our balance sheet down very, very smoothly. We have a new tool – the ability to pay interest on excess reserves, which means that the growth of our balance sheet is not going cause a problem in terms of future inflation. But other people have different views. And so the bigger our balance sheet gets the more people worry about that potential consequence. If that caused people to be worried about the inflation outlook, that would be counterproductive to our goals in terms of monetary policy.

In standard theoretical model environments, long-run inflation expectations are perfectly anchored. In reality, however, the anchoring of inflation expectations has been a hard-won achievement of monetary policy over the past few decades, and we should not take this stability for granted. Models are by their nature only a stylized representation of reality, and a policy of achieving "temporarily" higher inflation over the medium term would run the risk of altering inflation expectations beyond the horizon that is desirable. Were that to happen, the costs of bringing expectations back to their current anchored state might be quite high.

Based on the historical experience with inflation in the United States and Japan, I personally expect our primary short-run concern to be disinflation rather than inflation. The growth rate of the core PCE inflation index over the past year is 1.3 percent. This rate is well below the 2 percent rate that most members of the FOMC expect to see in the long run, as revealed in their published forecasts.

There remains substantial excess capacity in the economy, and while I expect that we will see positive growth in the third and fourth quarter of this year, it will not be sufficient to make significant headway in improving labor-market conditions right away. This significant excess capacity in labor markets has the potential to be disinflationary at a time when the inflation rate is already below where we expect it to settle in the long run.

Similar to other important economic forces—like the output gap—the lack of observability and difficulty in measuring inflation expectations represent a powerful challenge for monetary policymakers. Here is how I approach the issue. Initially, we can attempt to directly assess each important force for future inflationary pressures. This approach could construct a risk assessment for inflation pressure indicators and would include all of the factors cited above, at a minimum, along with an assessment (or weighting) of their importance.⁸

I have a reputation for being the most “hawkish” participant in the deliberations of the Federal Open Market Committee. I do not particularly like ornithological nomenclature—I would rather be considered a wise owl (and I certainly do not wish to be anybody’s pigeon). But I have a record that substantiates that “hawkish” reputation, having voted five times against monetary accommodation during the commodity-driven price boom of 2008. I consider inflation an evil spirit that rots the core of economic prosperity and must never, ever be countenanced. But it is clear to me that in this environment, inflation is unlikely to present a serious threat given the pervasive bias in the U.S. economy toward wage cuts and freezes, rising unemployment, the widespread loss in wealth that has resulted from both the housing and equity market corrections, continually declining consumption and business investment, and the anemic condition of the banking and credit system, all of which reinforce downside price pressures in a global economy groaning with excess capacity.

It seems to me that a change in the conduct of monetary policy following the experience of the 1970s has probably caused inflation expectations to become better anchored, explaining why recent oil shocks have inflicted relatively little damage on the economy. This hypothesis could at least partly explain why the huge run-up in energy prices through the middle of last year was not accompanied by rising wage demands. That in turn enabled the Fed to follow an easier monetary policy that gave greater weight to the output effect of rising oil prices than would have otherwise been possible.

Since mid-2008, oil prices have, of course, plummeted. But the extraordinary weakness in the economy means that the usual trade-offs associated with such supply shocks are absent right now. Any boost to spending from falling oil prices will be more than welcome in the current circumstances. And with inflation now below desirable levels, a decline in inflationary expectations that could push core inflation down over time would be most unwelcome. I argued earlier that the Fed’s inflation credibility helped over a number of years to keep inflationary expectations anchored in the face of rising oil prices and high headline inflation. My hope is that inflationary expectations will remain similarly well-anchored now, serving to stabilize core inflation. The FOMC’s recently released longer-run inflation projections should be useful in this regard, helping to reinforce inflation expectations of around 2 percent.

Currently, significant excess capacity in the economy risks lowering inflation and inflation expectations.  Since short-term interest rates are effectively zero, reductions in inflation expectations imply a higher real interest rate – and, effectively, tighter monetary policy.  So the additional clarity on the long-run intentions of monetary policy (as reflected in the longer-range forecasts) might keep inflation expectations well anchored[Footnote 4] and real interest rates low enough to help get the economy moving again. 

An important consideration involves what the long-run goal for inflation should be, given recent experience.  Twice this decade, short-term interest rates have approached zero, and the probability of possible deflation has risen significantly.  In light of this experience, some might conclude that the implicit inflation target has been too low.  A fruitful area for future research would be to re-consider the likelihood and the cost of hitting the zero lower bound, and what that cost implies for setting inflation targets.[Footnote 5]