You can see in the SEP that, by the end of 2017, many participants are anticipating that rates will return to what they think are normal longer-run levels. But the economy in their view will have probably gotten back to normal levels of unemployment and near-normal levels of inflation sometime in 2016...

...There are a number of different explanations that participants give, but a common view on this is that there have been a variety of headwinds resulting from the crisis that have slowed growth, led to a sluggish recovery from the crisis, and that these headwinds will dissipate only slowly...  An example would be the fact that mortgage credit really is at this point available really to those with pristine credit. Credit conditions there are abnormally tight...In addition, we have had slow productivity growth, and a slow pace of potential output likely depresses the pace of investment spending.  And so those are some of the things that participants mentioned as why it will take some time to get back to normal...

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We stayed low for a very long time. We have been at zero for a very long time, and below the levels that some common policy rules would now be suggesting, given the level of unemployment and inflation... And similarly, we could make a similar statement with respect to where -- where the funds rate would stand relative to the recommendations of rules. So that would -- that would take some time to return to those kinds of levels.

Richmond Fed President Jeff Lacker said he believes the central bank will not raise its target for short-term interest rates until next year. In an interview in his office this week, Lacker called that scenario “pretty likely,” adding that he does not think the Fed is behind the curve in withdrawing its support for the nation’s economic recovery.

“I don’t see signs of that,” he said.

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Lacker is a prime example. His dissents in 2012 were driven by two factors: discomfort with the Fed’s official commitment to keeping rates near zero and its purchases of mortgage-backed securities to help the housing market. The latter was an inappropriate use of Fed power, Lacker has long argued, in which the central bank effectively picked winners and losers in the credit markets.

“I think matters of very important principles are at stake,” he said in the interview. “We’re in uncharted territory with regard to the expansiveness of how people talk about what the central banks can do and ought to do.”

I was uncomfortable with QE3, the program whereby we committed to a sustained purchase of $85 billion per month of longer-term U.S. Treasury bonds and mortgage-backed securities (MBS). I considered QE3 to be overkill at the time, as our balance sheet had already expanded from $900 billion to $2 trillion by the time we launched it, and financial markets had begun to lift off their bottom. I said so publicly and I argued accordingly in the inner temple of the Fed, the Federal Open Market Committee (FOMC), where we determine monetary policy for the nation. I lost that argument. My learned colleagues felt the need to buy protection from what they feared was a risk of deflation and a further downturn in the economy. I accepted as a consolation prize the agreement, finally reached last December, to taper in graduated steps our large-scale asset purchases of Treasuries and MBS from $85 billion a month to zero this coming October. I said so publicly at the very beginning of this year in my capacity as a voting member of the FOMC. As we have been proceeding along these lines, I have not felt the compulsion to say much, or cast a dissenting vote.

However, given the rapidly improving employment picture, developments on the inflationary front, and my own background as a banker and investment and hedge fund manager, I am finding myself increasingly at odds with some of my respected colleagues at the policy table of the Federal Reserve as well as with the thinking of many notable economists.

[W]ith low interest rates and abundant availability of credit in the nondepository market, the bond markets and other trading markets have spawned an abundance of speculative activity. There is no greater gift to a financial market operatoror anyone, for that matterthan free and abundant money. It reduces the cost of taking risk. But it also burns a hole in the proverbial pocket. It enhances the appeal of things that might not otherwise look so comely. I have likened the effect to that of strapping on what students here at USC and campuses elsewhere call beer goggles. This phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive. And this is, indeed, what has happened to stocks and bonds and other financial investments as a result of the free-flowing liquidity we at the Fed have poured down the throat of the economy.

MULVANEY: But if you've got tremendous losses on your balance sheet because of higher interest rates, you're paying out higher interest to the banks that keep their excess reserves (inaudible). You're (ph) negative cash. Where does the money come from?

BERNANKE: They come from the income -- they come from the income from our -- from our assets. We -- it's just that we have -- from an accounting perspective, we don't have to recognize those losses unless we sell 'em.

MULVANEY: Is there ever a circumstance where you go to your shareholders for a capital call?

BERNANKE: No.

Dudley said there “should be no anxiety” about whether the Fed’s enlarged balance sheet will cause the economy to overheat. The ability to pay interest on excess reserves “basically allows us to keep credit expansion under control,” he said. Market participants “accept this view,” as long-term inflation expectations are “very well-behaved,” he said.

We want to make sure we’re not pushing on a string... Money is basically free, gas tanks are full. Who steps on the gas pedal? Who engages the transmission?

Of course, those who worry about the inflationary consequences of our balance sheet may be looking to the future. As the economy improves, banks may use their reserves to rapidly expand business lending – increasing economic activity and putting upward pressure on inflation.  But as Chairman Bernanke has emphasized, the Federal Reserve has at its disposal a variety of tools that will allow it to remove reserves from the banking system once economic conditions get closer to normal. Thus the fear that our large balance sheet and the large stock of reserves in the banking system will cause inflation – either now or down the road – seems misplaced to me.

[I]f growth picks up next year, as I and many other FOMC participants expect, the precautionary demand for liquidity by households, firms and banks will diminish. At some point we will need to respond by reducing the provision of liquidity to the banking system to prevent inflation from accelerating, as it often can when a recovery picks up steam. Further balance sheet expansion now could require more rapid balance sheet reduction later on, complicating the withdrawal of monetary stimulus when it becomes necessary to maintain price stability. It is appropriate, therefore, that the FOMC has committed to "regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed."

Even with the best of intentions, if we don’t act aggressively and promptly, we may find ourselves behind the curve and at risk for substantial inflation. I think we need to bear in mind this future potential complication when considering further expansion of the Fed’s balance sheet.

Monetary policy can surely have great influence--most notably by establishing stable prices and appropriate financial conditions--on the real economy. By my way of thinking, the risk-reward ratio for Fed action peaks in times of crisis when it has a full toolbox and markets are functioning poorly. But when non-traditional tools are needed to loosen policy and markets are functioning more or less normally--even with output and employment below trend--the risk-reward ratio for policy action is decidedly less favorable. In my view, these risks increase with the size of the Federal Reserve's balance sheet. As a result, we cannot and should not be as aggressive as conventional policy rules--cultivated in more benign environments--might judge appropriate.

What I envision from the current vantage point is an anemic recovery, but not one that slips into reverse gear. Thus, barring an unforeseen shock, I have concerns about the efficacy of further expanding the Fed’s balance sheet until our political authorities better align fiscal and regulatory initiatives with the needs of job creators. Otherwise, further quantitative easing might be pushing on a string. In the worst case, it could flood the engine of the economy with gas that might later ignite inflation.

I think it is abundantly clear to the market that regardless of the language the FOMC employs to describe its deliberations and intentions, the consensus of the committee is to keep the price of money—the cost of the gas needed for our nation’s economic engine—low until the committee is confident that the gears of the economy have begun to mesh more robustly.

Which focuses attention on the size of our balance sheet and whether we will expand it. Personally, I would be reluctant to do so unless or until fiscal and regulatory initiatives are aligned with the needs of job creators. Otherwise, further accommodation might be pushing on a string.   In the worst case, it could flood the engine of the economy with gas that might later ignite inflation. Of course, if the fiscal and regulatory authorities are able to dispel the angst that they are reportedly causing, further accommodation may not be needed because the liquidity that has been built up on corporate balance sheets and in the excess reserves of banks might then be released into the economy and spur job creation.

In my view, any judgment to expand the balance sheet further should be subject to strict scrutiny. I would want to be convinced that the incremental macroeconomic benefits outweighed any costs owing to erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility.

Most policymakers do not tend to put too much stock in the very simple theories relating excess reserves to money and inflation that I mentioned earlier. But we are aware that the size of our balance sheet is a potential source of policy stimulus, and we need to be alert to the risk that households, businesses, and investors could begin to expect higher inflation based partly on an expanded central bank balance sheet. As always, the Federal Reserve monitors inflation developments and inflation expectations very closely and any signs of a significant deterioration in the inflation outlook would be a matter of concern to the FOMC.

[W]e should get our balance sheet back down to less than a trillion dollars to allow us to engage in short-term securities transactions.