... [M]onetary policy works only with a lag and hence cannot offset these near-term effects; rather, the recent cuts in the federal funds rate are intended to help bring economic activity back to maximum sustainable levels over time, and such an outcome can be seen in the broad contours of the FOMC projections.

However, the conclusion that inflation is determined only by monetary policy choices need not hold in the short-to-medium run. In the shorter term, central banks do not usually offset completely the effects of shocks to supply or prices--of which a change in the relative price of imports is an example--in part because any monetary action made in response will take time to be effective.

Even if policy is now well positioned, as I think is likely to be the case, it will still take some additional time for inflation to unwind due to lags between policy actions and their impacts on economic activity and inflation. These lags can be anywhere from several months to a couple of years. This means that we have yet to see the full effects of the series of 17 funds rate increases—some are probably still in the pipeline.

Monetary policy must be forward-looking because policy influences inflation with long lags.  Generally speaking, a change in the federal funds rate may take an estimated 12 to 18 months to affect inflation measures. 

The existence of lags in monetary policy has two important implications.  First, the Federal Reserve should only respond to high current inflation to the extent that it is expected to be highly persistent.  if inflation pressures are seen to be temporary and policy is currently restrictive, maintaining the current policy stance may be consistent with a reduction in inflation over time.  Second, given the existence of policy lags, the actions that the Federal Reserve took over the past year in raising the federal funds rate have not yet had their full effects on the economy or inflation.

On the risk of the Fed losing credibility:  Of course there's always a risk. But we watch pretty carefully and we don't want to see that risk materialize. Certainly as long as I have anything to do with this process I will be pushing hard for a policy that is as tight as it has to be, as disciplined as it has to be, to keep long-run inflation within bounds. And that would be lower than today's inflation.

{Our response} depends on what we know about why {inflation is} hanging high, if that's the hypothesis we're exploring. We need to look at why and we need to look at the various lags in this system.

If we believe that we're headed off in the right direction then we can be patient. We can be patient and sit there and not create a disturbance in the economy. 

The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still "in the pipeline." ...

...[P]olicy must be flexible and ready to adjust to changes in economic projections. In particular, as the Committee noted in the statement issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by our analysis of the incoming information.

The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth.  In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still "in the pipeline."

Generally speaking, a change in the federal funds rate today may take an estimated 12 to 18 months to affect inflation measures.

The Federal Reserve should only respond to high current inflation to the extent that inflation is expected to be very persistent.  Indeed, to the extent inflation pressures are seen as temporary and policy is currently restrictive, maintaining the current policy stance may be consistent with a reduction in inflation over time.  Of course, the other aspect of this is that if inflation pressures remain elevated, then they will affect inflationary expectations requiring more forceful actions later.

I am increasingly concerned about the well-known long and variable lags in monetary policy—specifically, that the delayed effects of our past policy actions might impact spending with greater force than expected. This could show up especially in the housing market and via housing prices and balance sheet effects on consumer spending. While I expect the housing sector to slow somewhat, I will be highly alert to the possibility of the policy tightening going too far.

Although monetary policy is less accommodative, it will continue to support economic activity in the near term.  Because of the lags with which monetary policy affects the economy, monetary policy accommodation over the past year will continue to act as an economic stimulant in the near term, though clearly not as much of one as in the past several years.  Over the second half of this year, our moves to remove monetary accommodation should help ensure the economy settles into a growth rate that is consistent with the economy’s long-run growth potential....

...However, as the funds rate has entered the neutral range and risen to the upper end of that range as estimated by most analysts, it has become more difficult to know in advance what the next move is likely to be or when the next move should occur.

Signs point to another robust performance in the fourth quarter, so growth for the last half of 2005 could well come in noticeably above the potential rate.  This positive performance suggests that the overall economy has been quite resilient in absorbing the impact of the storms [Hurricanes Katrina and Rita].  For 2006, it seems likely that this strength will continue in the first half, as rebuilding kicks in.  Then, in the second half, a couple of factors are likely to cause economic growth to settle into a trend-like pattern.  One of the factors is the winding down of the rebuilding effort.  The other is the lagged effect of monetary policy tightening; in other words tighter financial conditions will have some dampening impact on interest-sensitive sectors, such as consumer durables and housing.

In the case of hurricanes, the negative effects are most likely to be felt over the next six months.  If monetary policy were to increase the level of accommodation, the benefits would not likely be felt until next year.  By that time, the rebuilding effort would be well underway, and there might be a danger that monetary policy stimulus could combine with the sizeable fiscal stimulus to overheat the economy and lead to higher inflation.

I think the right approach to dealing with uncertainty is for policymakers to increase the clarity with which they convey to the public both monetary policy objectives and strategy. Monetary policy affects the economy not primarily through short rates, but instead through its effects on asset prices, including bond rates and equity prices. If financial markets have a good understanding of the central bank’s objectives and strategy, they will react appropriately to policy moves. This allows markets and policymakers to work together rather than at cross purposes—strengthening the transmission mechanism and shortening policy lags.

As we keep an eye on prices, it’s important to keep in mind that monetary policy acts with a considerable lag, and economic circumstances can and do change quickly. If you wait to see concrete evidence that inflation has taken hold, then it’s already too late to stop it.