An efficient monetary policy {following an oil shock} should attempt to facilitate the needed economic adjustments so as to minimize distortions to economic efficiency on the path to achieving, over time, its dual objectives of price stability and maximum employment.⁹

In particular, an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation.  By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago.  Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains.

In the long run, in my view, it is total inflation – rather than core inflation, which excludes the volatile food and energy components – that should be the focus of monetary policy.

Price stability has multiple interpretations. In the late 19th and early 20th centuries, price stability meant that variations in the general level of prices would be transitory: the price index would revert to a mean. In recent policy discussions, price stability generally is interpreted as a small positive rate of inflation. Under these conditions, the level of prices does not revert to a constant, but trends upward. I accept this latter definition of price stability. There may be theoretical and practical reasons to believe that the best price indexes we have available are subject to upward biases. While I am not a big fan of the upward-bias argument—after all, the best-available adjustments are already made to the indexes—I admit that I do not have better measures myself. My preferred definition of price stability is that trend inflation, correctly measured, is zero. In practice, this likely converts into a trend in measured inflation on the order of ½ to 1½ percent, depending on the particular price index referenced.

You might wonder why a central banker would be concerned with fiscal matters. Fiscal policy is, after all, the responsibility of the Congress, not the Federal Reserve. Congress, and Congress alone, has the power to tax and spend. From this monetary policymaker’s point of view, though, deficits matter for what we do at the Fed. There are many reasons why. Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road.
...
Earlier I mentioned the Fed’s dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers’ purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul VolckerEven the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period.

So-called 'headline inflation,' boosted by outsize increases in energy and food prices, is clearly too rapid for comfort.

Core measures of inflation, which abstract from fluctuations in prices of food and energy, have been better-behaved, perhaps because real incomes and spending have been restrained by the run-up in food and energy costs.

As reported by Market News International

The wisdom of emphasizing a forward-looking strategy over the Taylor rule approach may depend in part on policymakers' forecasting acumen. To estimate the neutral rate, central bankers must forecast how the forces affecting aggregate demand and supply will reconcile during the forecast period. Moreover, policymakers must project how changes in the federal funds rate--past and anticipated--will interact with asset prices, credit provision, and real-side variables. Under the best of circumstances, these forecasts are subject to meaningful uncertainty. Thus, peering into the future and acting on what we think we see will invariably lead to some mistakes, certainly with the benefit of hindsight. Ignoring the future altogether, however, hardly seems the wisest course.

Moreover, the Taylor rule approach does not remove uncertainty.

To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.

The rise in commodity prices presents particular challenges for monetary policy because such increases both add to near-term inflationary pressures and damp demand. A tendency for increases in commodity prices to become a factor in ongoing pricing and wage-setting more generally would be a worrisome development that would over time tend to undermine economic welfare.

My expectations for moderating inflation and limited spillover effects from commodity price increases depend critically on the continued stability of inflation expectations. In that regard, year-ahead inflation expectations of households have increased this year in response to the jump in headline inflation. Of greater concern, some measures of longer-term inflation expectations appear to have edged up. If longer-term inflation expectations were to become unmoored--whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought--then I believe that we would be facing a more serious situation.

The Federal Open Market Committee will be monitoring inflation developments closely for any sign that our longer-run objective of promoting price stability is threatened.

I think there is a real danger and the psychology around inflation is beginning to change. Expectations about inflation are beginning to change and that is a major concern to me.

Once people start passing this on, start thinking about inflation as a way of life, behaviors change

As reported by Market News International and Reuters

 Much of the recent data have been disappointing. Over the past twelve months, the personal consumption expenditures (PCE) price index rose 3.2 percent, up from 2.5 percent over the prior year. An important reason for these disappointing numbers, of course, is the rise in commodity prices that I have discussed. Some of this increase has probably also passed through to core PCE price inflation, which excludes food and energy. This measure has averaged 2.1 percent over the past twelve months, and it is slightly above the range that I consider consistent with price stability.

Under present circumstances, judging future changes in commodity prices is obviously an important part of any inflation forecast. As I noted, future markets generally are expecting these prices to flatten out and remain at around today’s very high levels. If this happens, then the effects of commodity prices on inflation will dissipate. In order to continue to put upward pressure on inflation—which, after all, is the rate of change of prices—commodity prices would have to do more than remain at today’s high levels. They would need to keep on rising.

While this seems unlikely based on experience in recent decades, we can’t rule out this possibility. Futures markets have been expecting a leveling out of most commodity prices for several years now, and they keep being surprised by ongoing increases. As I mentioned before, in part, this could reflect growing supply limitations on some commodities, especially oil. However, there also is the possibility that commodity prices could fall in the future as the economic weakness in the U.S. and slowing in Europe could spread to the rest of the world, reining in demand for commodities. I mentioned before that there is an usually wide spread in Blue Chip forecasts for real GDP growth—well, not surprisingly, the dispersion for inflation forecasts is also unusually large at the present time, perhaps reflecting these divergent possibilities.

In the 1970s and early 1980s, the wage-price spiral was spun from the pass-through of rising food and energy prices to inflation, which was in turn passed along to wages and, then again, through to final goods prices. Fueling the movement were expectations that monetary policy would allow inflation to continue to rise for the foreseeable future.

I see little reason to believe that we have entered, or are about to enter, such a period of stagflation. For one thing, although current data on growth and inflation have departed from desirable levels, matters looked far worse 30 years ago than they do now.

For another, there is no evidence that wages have started to spiral up, as broad measures of compensation have expanded quite moderately over the past year. Moreover, productivity growth has been fairly robust, and, after incorporating its effects, unit labor costs were up by only ¼ of 1 percent over the past year. In addition, the slack in labor and product markets stemming from the weakening in economic activity that seems likely should put somewhat greater downward pressure on inflation going forward. Therefore, my forecast of the most likely outcome over the next couple of years is that total and core inflation will moderate from present levels.

Inflation is always a home-grown, monetary phenomenon that is ultimately under the control of a central bank. How quickly inflationary impulses filter through to wages and prices, however, depends on many things—most importantly, on the state of inflation expectations and on the degree of slack in an economy. When the public generally anticipates inflation and when an economy is operating at full capacity, monetary excesses can quickly translate into higher prices and wages.

Indeed, we have recently witnessed food riots in some developing countries. While sometimes devastating, these global relative-price pressures are not the same thing as inflation.

Inflation was disappointing as well last year. The price index for personal consumption expenditures rose by 3.6 percent during 2007, compared to 2.3 percent the year before. Rapid increases in food and energy prices were the obvious culprits, but that provides little comfort to this central banker. The Federal Reserve is responsible for keeping total inflation low and stable—including food and energy prices. While the effects of unexpected commodity price increases are difficult to offset rapidly, an appropriate monetary policy would ensure that such shocks even out over time and do not impart a persistent inflation bias—either up or down.