[T]he data suggest to me that long-run inflation expectations are currently around 2 percent.  That said, I think it should be clear that the evidence points to a range of estimates; moreover, this range is itself uncertain because of the assumptions needed to tease point estimates from the available data.  So, although I think that 2 percent is a reasonable estimate of current long-run expectations, I don’t want to overstate the precision of this figure.  We still face some uncertainty in this regard, and policymakers must be cautious about placing too much confidence in any one estimate.  

If long-run expectations are in fact about 2 percent, where is actual inflation likely to be headed in the next year or two? While recognizing how embarrassingly wrong such prognostications often turn out to be, I think that we can be reasonably optimistic that core PCE inflation will gradually drift down from its latest twelve-month reading of 2-1/4 percent...

Looking to the medium term, I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy. For the most part, this assessment--which I should stress is subject to considerable uncertainty--flows from my view that long-term expectations appear to be well anchored at a level not very far below the current rate of inflation. If so, a substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming to bring about, as I noted earlier.

...I believe that a soft landing is the most likely outcome over the next year or two.  However, I hope my remarks so far make it abundantly clear that there are sizeable risks to this forecast and that I am especially concerned about the upside risks to our inflation forecast. 

If we get surprises -- because we are running on the high side of anyone's inflation objective -- that suggest inflation is not likely to be on a downward trend, then I think what I would advocate is that we ought to be ready to raise rates.

I prefer inflation to be between 1 and 2 percent—that's the range that I consider to be most compatible with the Fed's goal of price stability. The monthly inflation rates did come in lower toward the end of the year, and I was pleased to see the improvement. However, it is much too early to say that inflation is no longer a concern. So as I look ahead to this year, I see the economy with some solid underlying momentum behind it and inflation running too high.

Readings on core inflation--that is, inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated...

A waning of the temporary factors that boosted inflation in recent years will probably help foster a continued edging down of core inflation...  The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated. 

At this early juncture in 2007, I think it entirely reasonable to expect the economy to maintain an average pace of 3 percent growth for the year. And, if we at the Fed do our job well, we should be able to accommodate that growth rate while bringing inflation down below 2 percent

I wouldn’t rule out further increases in the federal funds rate if inflationary winds gain the upper hand. Indeed, if increases are needed, I would aggressively advocate for them. But for now, I am as comfortable with the inflationary outlook as a prudent central banker can be. No central banker can ever be smug about containing the risk of inflation, but I am pleased with the current direction of inflationary impulses.

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.

Inflation is a little higher than I'd like to see it.  I would like to see it come down.

The November inflation reports, however, have provided some tentative evidence suggesting a moderating trend. For example, the three-month average rate of change in the core PCE price index fell to 1.8 percent in November. That inflation measure has exhibited substantial oscillations, however – it fell to 1.8 percent in February of last year before rising to 2.9 percent within three months when energy prices surged. In view of the recent record, it will take several months worth of data to provide statistically convincing evidence of a moderation in inflation. In the meantime, the risk that core inflation surges again, or does not subside as desired, clearly remains the predominant macroeconomic policy risk.

On the policy outlook:
     ``It is highly data dependant in that it is responding to what happens over time. So I remain comfortable with the current stance of policy.  I'm alert to the fact that there are upside risks to inflation and with respect to growth, it could go either way.''

On unemployment:
     ``I expect it to inch up ever so slightly, not greatly but marginally. Perhaps by the end of the year to be a little closer to 5 percent."
     ``A period of slightly subpar growth in the economy would in principle create a little more slack in the labor markets.''
     ``Tight labor markets can be a source of inflation pressure and there are a lot of questions about truly how tight labor markets are."
     ``The unemployment rate is low enough that it should be a red flag to policy makers. ''

On whether she has a bias toward raising rates:
     ``I did indicate in the speech that I do remain concerned about upside risks to inflation. That is essentially what the last statement said. There are upside risks to inflation and we remain concerned. ''

From audience Q&A as reported by Bloomberg News

Inflation has been and remains a challenge, though recent data provide a bit of assurance that price pressures may be beginning to ebb.

My predominant concern remains the risks to the inflation outlook. We've seen some welcome easing in inflation in the past couple of months, and I'm hopeful this development will continue. But there is still the risk that resource pressures or other factors, such as elevated inflation expectations, could prevent actual inflation from falling in a timely fashion.

In my view, however, what we are seeing in the recent information on factory output and capital spending is not the leading edge of general economic weakness but instead an adjustment to a sustained pace of expansion that, necessarily, is less rapid than that from mid-2003 to mid-2006...

...

So, despite the recent favorable price data, I believe it is still too early to relax our concerns about whether the run-up in price pressures in the spring and summer of last year is truly unwinding and whether it is unwinding rapidly enough to forestall a pickup in inflation expectations.