Deposit institutions are holding over a trillion dollars in excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling.

Why might households expect an increase in inflation? The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve’s debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

The asset purchases are being financed by reserve creation, or ‘printing money.’  The monetary base has expanded rapidly.  In contrast to the liquidity programs, the expansion of the monetary base associated with the asset purchase program is likely to be very persistent.  This has created a medium-term inflation risk.

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

If one examines the inflation record of the United States, and of many other industrial economies for that matter, since the early 1980s, it appears that central banks have largely succeeded in delivering diminishing and, ultimately, low inflation. I can think of no reason why this cannot continue.

Looking ahead, prognosticators this year have divided into several different camps. Some believe that high unemployment necessarily will lead to continually falling inflation for several years, and they are concerned about the risk of outright deflation. I personally have thought the risk of deflation was overstated, and for the first three months of this year, inflation has averaged 2 ¼ percent – both core prices and overall prices. Another camp places significant weight on the public’s expectations, and as near as we can figure, those are fairly well anchored around 2 percent. And finally, a third camp sees the rapid growth in our balance sheet, notes the historical association between rapid money growth and subsequent inflation, and wonders whether inflation will accelerate when the economy begins to recover.

Where do I stand? While I gravitate to the second camp – the one that views stable expectations as likely to anchor inflation in the near term – members of the third camp have identified inflation risks that are quite legitimate. The challenge for us on the Federal Open Market Committee will be to shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation. The danger is that we will not shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation. Choosing the right time to withdraw that stimulus will be a challenge, and I believe it will be very important to avoid the risks of waiting too long or moving too slowly.

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.

Research by my staff shows that while the SPF forecasts were sensitive to headline inflation data in the past, these forecasts have responded in recent years to core rather than headline inflation data.4 This finding suggests that professional forecasters no longer expect relative price changes to have a persistent effect on inflation.

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]

Federal Reserve Bank of St Louis President James Bullard said on Saturday that an explicit inflation target would help policy-makers prevent either deflation or inflation from taking hold in the United States.

"An inflation target would help focus expectations," he told a panel discussion during the annual meeting of the American Economic Association.

...

"Maybe now would be a particularly good time to do that because you have this possibility of expectations drifting off to deflation or a lot of inflation. ... I think it would help," said Bullard

At a time of great concern about financial turmoil, we should keep in mind that instability in the general level of prices — whether inflation or deflation — is itself a significant source of financial instability. Federal Reserve officials, myself included, have spoken of the importance of keeping inflation expectations well anchored. When the public's inflation expectations begin to rise, that can contribute to higher actual inflation. It is therefore important for the Fed to maintain its credibility to keep inflation low and stable when large relative price movements in energy and food commodities led to large increases in the consumer price index.

The near-term economic outlook is not encouraging. The incoming data in September and October have been worse than expected, and these results pushed my staff and me to revise downward the Atlanta Fed's outlook for the economy.

I foresee substantial weakness at least through the first half of 2009. This weakness will exacerbate the employment picture. In my outlook, unemployment will rise some more.

If there is anything positive in this near-term outlook, it is the trajectory of prices. I expect headline inflation to decline over the coming months and fall into an acceptable range below 2 percent by 2010. Over the longer term, inflation experience is influenced by inflation expectations. Encouragingly, the University of Michigan consumer survey's reading for October shows a moderation in inflation expectations both for the year ahead and for the longer term.

(O)ne reason for the increased risk to inflation is the surge in commodity prices, particularly energy. Another has been high food prices. However, even excluding food and energy, so-called core inflation for personal consumption expenditures was up to 2.6 percent (year-over-year) in August. This rate is too high.

Early in the last century, the economist Irving Fisher offered a vivid metaphor for the movement of individual costs relative to the aggregate level of inflation. The general inflation, he said, can be thought of as the movement of the swarm of bees. He likened the relative movement of individual prices (both up and down) to the movement of individual bees within the swarm.

In my view, the compositional differences {between the CPI and PCE price index} don't clearly favor one index versus the other. While the level of the inflation rate measured by the two indices differs at any point in time, over the short term both generally give the same signal about the pattern of inflation.

Taken together, measures of both CPI and PCE inflation are important tools to help get a fix on the overall inflation picture, giving us a sense of whether the inflation is persistent or transitory along with other information needed to make informed policy decisions.
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I agree with those who say core inflation measures in isolation are an inadequate approach to determining the direction of overall price changes. Like you, I ultimately care about the trend rate of overall inflation, which I believe is ultimately the appropriate object of monetary policy.