Some fear inflation expectations are on the move in reaction to recent experience. As suggested a moment ago, I don't hold that view. But I feel that it's important to acknowledge that not enough is known about transitional periods from one state of expectations to another. Even though we're measuring expectations, there's an element of looking back to gauge their essence. I do not dismiss the view that we run the risk that by the time change in expectations is clear, it's too late. In my view, we need to know more about how and why inflation expectations shift.

That said, years of hard work by economists have gone into developing the measures of inflation expectations we currently track. And I have challenged our Atlanta Fed research staff to build on this progress.

Some have taken comfort in the fact that inflation has not yet been built into wage growth as evidence that inflationary expectations have not risen. But I am less sanguine because research indicates that by the time we have statistical confirmation that wages are increasing at rates higher than the rate of growth of productivity, a persistent rise in inflation most likely would already be in train.

I interpret the available economic theory and empirical evidence as indicating that a long-run average inflation rate of about 2 percent, or perhaps a bit lower, is low enough to facilitate the everyday decisions of households and businesses while also alleviating the risk of debt deflation and other pitfalls of excessively low inflation.

I want to make clear that the rise in inflation expectations in the 1970s was not caused by a wage-price spiral. That story has things backwards. The wage-price spiral was a consequence of the inflation and the unanchoring of expectations of inflation, not the other way around. And the unanchoring of inflation expectations was caused by the public’s loss of confidence in the Federal Reserve’s resolve to bring inflation back down. The credibility of the Fed’s promise to deliver price stability was lost.
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I want to emphasize that what we have been seeing in the economy this past year, and in my own outlook going forward, is very different from the 1970s, because I see the Fed as committed to keeping inflation expectations well-anchored. I agree with a statement Fed Chairman Bernanke made in June that the Fed will strongly resist an erosion of longer-term inflation expectations, because an “unanchoring” of those expectations would be destabilizing for economic growth as well as inflation.

The currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation.  If that were to occur, and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term.  A critical responsibility of monetary policy makers is to prevent that process from taking hold.
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In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process.

We're approaching a crossroads. The FOMC responded to the difficult economic conditions that emerged last year by easing monetary policy substantially. ... I am somewhat reassured by the recent data, which suggest that my biggest fears on the downside have, so far, been avoided. Of course, the underlying housing, credit, and commodity-price issues are far from fully resolved. My discussion of those issues makes clear that a lot of uncertainty surrounds my outlook. A lot could still go wrong.

But maximum sustainable employment is only one of our mandates. The other is low and stable inflation. In the wake of rapid increases in prices for gasoline and food, consumer survey measures of longer term inflation expectations have turned up. In contrast, other surveys, such as the Survey of Professional Forecasters, show little erosion in long-term inflation expectations. In addition, the anecdotes I hear are more consistent with credibility than with an upward wage-price spiral. In particular, my contacts uniformly report that they see no signs of general wage pressures.

On balance, I still see inflation expectations as reasonably well anchored and I anticipate that consumer survey measures will come down once oil and food prices stop rising. But the risks to inflation are likely not symmetric and they have definitely increased. We cannot and will not allow a wage-price spiral to develop.

As I began with a reference to Shakespeare, let me end with one as well: For monetary policymakers, "readiness is all." By this I mean that, in the face of these competing risks, we will monitor developments carefully and be prepared to act as needed to fulfill our mandate for sustainable economic growth and price stability.

Let me emphasize that I'm taking the recent inflationary pressures very seriously. A path to recovery involving stronger growth but with higher and persistent inflation would fit the old adage about winning the battle but losing the war.

For that reason, in my view, the current set of circumstances calls for being especially vigilant and attentive to public and business psychology as regards costs and prices. Policy needs to react decisively against signs of the onset of formal compensating practices, including contracts, that treat inflation as a persistent reality—in other words, something that must be lived with. Such signs are not apparent, and I don't expect them to materialize.

For the moment, higher headline rates of inflation have shown only a few tentative signs of embedding themselves in core inflation or in longer-term inflation expectations. However, policymakers around the world must monitor the situation carefully for signs that the increases in relative prices globally do not generate persistently higher inflation. Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.

MR. LACKER. Yes. I notice that in chart 18, in your TIPS-implied average inflationary plot to the ten-year horizon, you omit the Markets Group’s estimate. Is that because of skepticism on your part that leads you to judge it as inferior or an overabundance of humility? [Laughter]

MR. DUDLEY. The latter, of course. [Laughter]

MR. LACKER. It does, of course, show a slightly different trend, right?

MR. DUDLEY. It actually has increased a bit. But I have consistently shown just the Barclays and Board measures over the past few months, so this is not “pick and choose.”

Competitive trading markets are impressively effective mechanisms for weighing and amalgamating widely divergent views, and so one shouldn't ignore the information embodied in market prices, and I don't. The implied forecast misses have been predominantly on the high side in recent years, however. The risk for inflation dynamics is that elevated rates of increase in overall price level become embedded in expectations.

"We need to take steps to insure that inflation does not get out of control," Plosser said in an interview on the CNBC television network. "We need to act preemptively."

"It is certainly clear that rates will have to rise. The question is when."

As reported by MarketWatch.

My sense is that actual headline inflation in excess of 3.0 percent coupled with inflation expectations near 2.5 percent will not be compatible for long. If inflation remains elevated, inflation expectations will begin to move higher. Market participants, businesses, and consumers will come to view higher inflation as part of the economic landscape, in part because of doubts about the Fed’s ability and willingness to keep inflation contained. These expectations, if allowed to persist, will then feed into the equilibrium of the economy and will be difficult to reverse. In short, credibility is much easier to keep than it is to recover.

Should policymakers take into consideration persistent differences in headline and core measures of inflation? ...Let me stress that I do not have an answer to this question, but I think it has become an important concern for the FOMC. Again, what is new here is relative price trends in food and energy that may plausibly be expected to persist for some time. If it were just a matter of the food and energy components being volatile, I think a theoretical case could be made that these prices contain too much noise and so should be ignored in day-to-day policy decisions. Historically, the ex-food and energy calculation seems to have worked well, even though arbitrarily ignoring certain prices is not very elegant. With relative price trends, the ad hoc approach to this question is becoming increasingly untenable.

Regardless of its source, the presence of sluggish nominal adjustment brings to the fore three key elements driving wage and price dynamics: inflation expectations, supply shocks, and resource utilization...The tendency of some prices to adjust very quickly to changing circumstances in conjunction with sluggish adjustment in other prices and wages implies that large, sharp price movements, such as a change in the price of oil, lead to relative price distortions throughout the economy; these distortions imply that relative price shocks have important implications for the functioning of the economy.

The results of such exercises imply that, over recent history, a sharp jump in oil prices appears to have had only modest effects on the future rate of inflation. This result likely reflects two factors.  First, commodities like oil represent only a small share of the overall costs of production, implying that the magnitude of the direct pass-through from changes in such prices to other prices should be modest, all else equal. Second, inflation expectations have been well anchored in recent years, contributing to a muted response of inflation to oil price shocks.  But the anchoring of expectations cannot be taken as given; indeed, the type of empirical exercises I have outlined reveal a larger effect of the price of oil on inflation prior to the last two decades, a period in which inflation expectations were not as well anchored as they are today.