"A key factor in low long-term interests rates is that inflation
expectations have been anchored at low levels, so lenders are not
concerned about finding their returns wiped out by an acceleration of
inflation," Stern said. "That is one reason why I think it's important
(the Federal Reserve) remain committed, as I have suggested we are, to
low inflation."

     Despite the economic downturn, Stern doesn't see a return to the
environment of the early 1980s, when the Federal Reserve sharply
increased interest rates. He says people at that time felt nothing could
be done about double digit rises in inflation and expected it to
continue for years to come. "I think (current) inflation expectations
are pretty well anchored at low levels. ... I don't foresee a return to
that environment at all," he said.

From audience Q&A, as reported by Market News International

To date, inflation expectations appear to have remained reasonably well anchored, but any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank's policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring inflation expectations and the inflation situation more generally.

Fortunately, so far inflation expectations have not changed very much. But they bear watching because there are some signs that they, too, are edging higher. These may be early warning signs of a weakening of our credibility, and we must be very careful to avoid that.

As I said, my sense is that the most likely path is sluggish growth in the near term. But I can also see the possibility of a mild recession, similar to the last two we have experienced — in other words, shallow and with a slow recovery. What I don't expect is a more severe recession, like those we saw in 1982 or 1974. Keep in mind that monetary policy has moved aggressively in recent months, and that inflation-adjusted interest rates are now very low by historical standards. That by itself won't solve all our problems, but it will help support activity enough to at least avoid the worst outcomes, and possibly avoid a recession altogether.

Inflation expectations seem to be fairly contained right now. The upward movement we see does not at this point seem to be likely to result in runaway inflation.

From press Q&A, as reported  by Market News International

Stable expectations allow us if we so choose to go slow with policy adjustments because when the evidence comes in we can catch up. Or, if we respond too much from a Monday morning quarterback standpoint, we don't create any lasting problem, because inflation expectations are entrenched and therefore the market doesn't run away with expectations.

From press Q&A, as reported by Market News International

Anchored inflation expectations damp the pass-through of supply-related price shocks.  They also permit central banks to respond more forcefully to output fluctuations.  Most significantly, the improved inflation performance has come with, not at the expense of, output stability.  Although a consensus has not formed on how much of the "Great Moderation" in the growth of real output can be attributed to monetary policy, everyone agrees that at least a portion of it can.

Indeed, the management of expectations about future policy has become a central element of monetary theory, as emphasized in the recent synthesis of Michael Woodford (2003).

As I look at the incoming inflation data, I would judge them to be consistent with expectations in this range; moreover, I believe that having expectations reasonably well anchored in this range has been a helpful influence on the path of actual inflation.  However, let me be clear: I do not subscribe to a deus ex machina view of the inflation process, in which inflation is driven solely by inflation expectations and is little influenced by the balance of aggregate demand and aggregate supply.  Indeed, I take the view that expectations of future resource utilization are also an important factor affecting inflation outcomes.

If households and businesses believe that the Federal Reserve will set monetary policy in a way that keeps aggregate demand in reasonable alignment with aggregate supply over time, then expectations of future resource utilization will be stable, and current resource utilization will provide less information about future inflation movements.  In that situation, which I believe describes the current environment, inflation expectations will be a key driver of inflation dynamics.

I believe there are still reasons to remain concerned about the risks to the inflation outlook. First, there are indications that the recent improvement may have been transitory, and that we may see inflation remain at this level, or perhaps even move up again. Second, the public's expectations of future inflation – an important determinant of inflation trends – appear to be inconsistent with further reductions in inflation.

As a card-carrying monetarist, I argued the steady money growth case vigorously in years past, and it is still my conviction that a central bank ignores money growth at its peril...

Everything Milton argued about money stock control is true, but the effect of inflation expectations on the practice of monetary policy itself was, I believe, a missing element in the analysis...

...I believe that the Fed’s actual adjustments of its federal funds rate target have yielded superior outcomes since 1982 to what we would have observed under steady money growth. I also believe that advances in knowledge permit us to say with some confidence that these gains are not just an accident of Alan Greenspan’s special skills and intuition.

An indirect but elegant way to make the point that inflation expectations remain imperfectly anchored comes from a statistical analysis of inflation by Stock and Watson (2007). Stock and Watson model inflation as having two components, which may be interpreted as the trend and the cycle. Changes in the trend component are highly persistent whereas shocks to the cyclical component are temporary.²  The key finding of this research is that the variability of the trend component of inflation (and thus the share of the overall variability of inflation that it can explain) appears to have fallen significantly after about 1983. That is, unexpected changes in inflation are today much more likely to be transitory than they were before the early 1980s. Because it seems quite unlikely that changes in inflation could persist indefinitely unless long-run expectations of inflation also changed, I interpret the Stock-Watson finding as consistent with the view that inflation expectations have become much more anchored since the early 1980s.

I pose three questions to researchers, the answer to any of which would be quite useful for practical policymaking.

First, how should the central bank best monitor the public's inflation expectations?  ... Do we need new measures of expectations or new surveys? Information on the price expectations of businesses--who are, after all, the price setters in the first instance--as well as information on nominal wage expectations is particularly scarce.

Second, how do changes in various measures of inflation expectations feed through to actual pricing behavior?...

Third, what factors affect the level of inflation expectations and the degree to which they are anchored?...

Similar logic explains the finding that inflation is less responsive than it used to be to changes in oil prices and other supply shocks. Certainly, increases in energy prices affect overall inflation in the short run because energy products such as gasoline are part of the consumer's basket and because energy costs loom large in the production of some goods and services. However, a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent "wage-price spiral." With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices. A related implication is that, if inflation expectations are well anchored, changes in energy (and food) prices should have relatively little influence on "core" inflation, that is, inflation excluding the prices of food and energy.

For instance, in the wake of Hurricane Katrina in late 2005, markets’ immediate response to rising energy prices suggested expectations of persistently rising inflation. Market participants, it seems, were uncertain as to how much of a run-up in general inflation the Fed would allow. Inflation expectations moved back down after a number of FOMC members made speeches emphasizing their focus on preserving low inflation. This episode illustrates both the potential for the Fed to influence inflation expectations and the extent to which market participants are at times uncertain as to how the Fed will respond to new developments.