In thinking about the economic outlook, I try to stay focused on underlying fundamentals because they determine the outlook for the economy over the medium run, the time horizon over which monetary policy can affect the economy. In my view, the underlying fundamentals supporting the U.S. economic expansion remain sound. These include accommodative monetary policy, household balance sheets that have improved greatly since the recession, continued progress in the labor market, a more resilient banking system, and low oil prices. There are risks around all forecasts, but my modal forecast has been that over the next two years the U.S. economy will continue to expand at a pace slightly above its longer-run trend, which I estimate to be about 2 percent; that the unemployment rate will remain slightly under its longer-run level, which I estimate to be about 5 percent; and that inflation will continue to gradually return to the Federal Reserve's 2 percent target.

So it’s not just about is the economy evolving in line with your forecast, but how confident you are about that continuing in the future. I think it’s important to emphasize, it’s not just how the economic data comes in, but how that economic data then influences your expectations about the future outlook. So data that affects the outlook is what really matters.

Typically, when you see data that doesn’t fit what you anticipate, and when you don’t have a good explanation for it, even ex-post, you probably want to discount that information a little bit.

The framework for implementing monetary policy has evolved further in recent years, reflecting both advances in economic thinking and a changing policy environment. Notably, following the ideas of Lars Svensson and others, the FOMC has moved toward a framework that ties policy settings more directly to the economic outlook, a so-called forecast-based approach. In particular, the FOMC has released more detailed statements following its meetings that have related the outlook for policy to prospective economic developments and has introduced regular summaries of the individual economic projections of FOMC participants (including for the target federal funds rate). The provision of additional information about policy plans has helped Fed policymakers deal with the constraint posed by the effective lower bound on short-term interest rates; in particular, by offering guidance about how policy will respond to economic developments, the Committee has been able to increase policy accommodation, even when the short-term interest rate is near zero and cannot be meaningfully reduced further.The Committee has also sought to influence interest rates further out on the yield curve, notably through its securities purchases. Other central banks in advanced economies, also confronted with the effective lower bound on short-term interest rates, have taken similar measures.

“I’ll be surprised if I’m advocating a tightening in policy” this year, Federal Reserve Bank of Chicago President Charles Evans said. “I certainly think strong policy accommodation continues to be appropriate because the unemployment rate is 8.8% and inflation continues to be low, certainly on an underlying basis,” the official said.

He added “as long as year-over-year underlying inflation, core inflation, is 1.5% or lower, I am extremely doubtful we need an adjustment in monetary policy.” He noted 2% is where he believes inflation should be, and explained “as we get up toward 2%, we would want to make some adjustments to policy.”

As reported by Dow Jones

[B]ecause monetary policy typically acts with long lags on the economy and price level, the choice of when and how to exit will depend on forecasts. We will need to begin withdrawing extraordinary monetary stimulus well before the economy returns to high levels of resource utilization.

Central banks should be wary of placing too much faith in model-based analyses, which are necessarily predicated on past empirical correlations and relationships. As we have seen, financial innovation can induce structural changes that can importantly alter the way financial institutions, markets, and the broader economy respond to shocks. For this reason, policymakers should take a critical approach to evaluating analyses of this sort, and should always probe to find the sensitivity of results to unstated assumptions that may no longer be valid.

Core inflation for personal consumption expenditures was up to 2.6 percent (year-over-year) in August. In my opinion, this rate has been high...Although some risks to the inflation outlook remain, a forward-looking assessment would put less weight on inflation concerns than earlier this summer.
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The outlook for real economic activity likely will result in production, spending, and labor markets being very sluggish in the second half of this year and well into 2009. I expect that such activity will then pick up as the housing and financial markets gain headway in working through their problems. Such progress would be signaled by stabilization in construction and improvement in credit flows.
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There is, of course, a level of cloudiness in any economic forecast. In the current situation, the substantial stress in the financial markets has led to an unusually high degree of uncertainty. This is because it is extremely difficult to assess how the turmoil will influence markets and how policy responses to address the economic unrest will play out over time...We at the Federal Reserve continuously reevaluate the stance of monetary policy in light of current and forecasted conditions, as well as our assessments of the risks to our long-term objectives of maximum sustainable growth and price stability. Currently, these risk assessments must factor in the substantial uncertainties in the outlooks for growth and inflation that I just described. These uncertainties certainly pose difficult challenges for policymakers.

Given the likely drawn-out nature of the prospective adjustments in housing and financial markets, I see the most probable scenario as one in which the performance of the economy remains subpar well into next year and then gradually improves in late 2009 and 2010. As credit restraint abates, the low level of policy interest rates will begin to show through into more accommodative financial conditions. This improvement in financial conditions, together with the gradual stabilization of housing markets and the stimulative effects of lower oil and commodity prices, should lead to a pickup in jobs and income, contributing to a broad recovery in the U.S. economy.

At the same time, inflation seems likely to move onto a downward track. If sustained, the recent declines in commodity prices should soon lead to a sharp reduction in headline inflation. In addition, I expect core inflation to slow from current levels as lower commodity prices and greater economic slack moderate upward pressures on costs. Similar reductions in inflation abroad, as well as the recent appreciation of the dollar, should restrain increases in the prices of imported goods.

I would caution, however, that the uncertainty around my forecast is substantial. The path of the economy will depend critically on how quickly the current stresses in financial markets abate. But these events have few if any precedents, and thus we can have even less confidence than usual in our economic forecasts.

 In practice, policy decisions are likely to depend on more than the modal forecast used by the authors, such as the degree of uncertainty, the risks around the central tendency, and a weighting of the costs to public welfare from missing the forecast on one side or another. 

Maintaining price stability does not require that the central bank come down hard on every upward twitch in the inflation rate, but disciplined response is required when the inflation rate threatens to rise in a sustained fashion or fall into deflation. Central bankers need to apply their best judgment, and they will not always be correct in those judgments. But if they have a good record and the market retains confidence that the central bank will correct its mistakes, errors in judgment will not do lasting damage. I myself rely heavily on market measures of inflation expectations in forming my judgments and in deciding what policy risks to run—in an uncertain world, it is always the case that policy judgments depend on probabilistic calculations.

My own take on what “moderate pace” means is that real GDP is likely to increase by roughly 3 percent over the four quarters of this year—particularly if the housing market is near an inflection point and no longer a significant drag on growth. But I want to emphasize that fluctuations in growth are normal and that no policy action is necessarily indicated if growth comes in somewhat above or below that outlook. When data come in outside the range expected, we need to understand the reasons and the likelihood that the departure will be sustained unless there is an offsetting policy response. Only then does it make sense to consider a policy response.

Regarding the outlook for inflation, I’ve said for quite some time that it might take a while for underlying price pressures to recede. Recent inflation data themselves, and other information relevant to judging the inflation outlook, suggest that the inflation rate is likely to fall into a reasonable range this year. If, however, core inflation seems to be settling at a rate above 2 percent, then such an outcome would be unacceptable to me. I put a very high weight on the Fed’s responsibility to maintain low and stable inflation.

At some point we’ll almost certainly see some surprises in the data. Long experience with economic forecasts indicates that we need to consider as a standard feature of the environment GDP forecast errors in the neighborhood of 1½ percentage points on a four-quarter ahead horizon. Thus, a forecast of 3 percent GDP growth should be expressed as 3 percent plus or minus 1½ percent. From experience, an outcome in this range has a probability of about two-thirds. The other one-third probability is divided equally above and below the range. Thus, the probability of an outcome significantly different from the baseline forecast is not small. The FOMC is prepared to respond when the outcome promises to depart from the baseline in a sustained way.

Whether the August decision to hold the target funds rate unchanged will turn out to be a pause in the process of raising rates, a longer-lasting stop or even the peak, will depend on the economy’s evolution in coming months.

In each of the next 16 consecutive meetings, the FOMC voted to raise the target for the federal funds rate by 25 basis points, finally pausing at 5¼ percent in August of this year. It appeared to some that policy was on autopilot, as the FOMC raised the target by 25 basis points meeting after meeting, apparently independent of incoming information. That view, I believe, was mistaken. When the FOMC began the series of rate increases, in June 2004, the statement included this sentence: “Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.” Similar language has appeared in every statement since and the minutes of the meetings have emphasized the same point.  What happened over the 18 months after June 2004 was, basically, that incoming data indicated that the economy was so close to the track expected earlier that there was no reason to depart from the “measured pace” of rate increases of 25 basis points at every meeting.

The central banks in New Zealand, Colombia, and most recently Norway have been announcing projections of their policy path for future interest rates. Publication of forecasts and policy projections can help the public and the markets understand central bank actions, thus decreasing uncertainty and making it easier for the public and markets to assess whether the central bank is serious about achieving its inflation goal.