TOOMEY:  Chair Yellen, your predecessor, Chairman Bernanke, both before this committee and in columns that he has discussed some of the limits of monetary policy, what monetary policy is capable of, and what it is not capable of.

And one of the things that he said -- I'm paraphrasing, but I think he said this on numerous occasion -- is that accommodative monetary policy has the limit of being only stimulative in the sense that it brings economic activity forward in time. It does not create new wealth, goods or services, but it shifts the timing of economic activity.  Do you agree with Chairman Bernanke in that respect?

YELLEN: Well, it sometimes does shift the timing of economic activity, brings forward a decision that might have been made later.

But I think the stance of policy also has repercussions that have a more longer-lasting impact on the state of demand. It is not only a matter of shifting purchases early by having more accommodative financial conditions. There are repercussions that can be longer- lasting than that.

“Monetary policy should not have the whole load of getting us out of this phenomenon,” Mr. Greenspan said. “It’s fundamentally a fiscal problem.”

One of the challenges for monetary policymakers is making low-frequency policy in a high-frequency world. We need to extract the signal about where the economy is headed from economic and financial market information that can often be noisy.

My own forecasts tend to have some consistency over time because I try to stay focused on underlying fundamentals and the medium-run outlook.

But the underlying health of the U.S. economy, I consider to be quite sound. I think it's a myth that expansions die of old age. I do not think that they die of old age. So, the fact that this has been quite a long expansion doesn't lead me to believe that its days are numbered.

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So when you say that central banks often kill {expansions}, I think the usual reason when that has been true is that central banks have begun too late to tighten policy and they've allowed inflation to get out of control. And at that point, they've had to tighten policy very abruptly and very substantially, and it's caused a downturn, and the downturn has served to lower inflation.

I continue to hold the view, as expressed in the FOMC’s statement of long-term goals, that monetary policy has the unique ability to determine inflation over time. That ability is independent of whether or not there is a reliable Phillips curve correlation. Moreover, it remains true in a world with interest on reserves and large bank reserve account balances. The effect of monetary policy on real activity, on the other hand, is likely to be transitory, which suggests caution in trying to use monetary policy to have significant real effects over the medium term. Even more caution should apply, given the state of our understanding, to the notion that monetary policy should respond to signals of incipient financial instability, an idea that has received considerable attention since the crisis.

While the expected neutral funds rate is something that may be relevant, estimating and communicating a value with any confidence would be challenging. Measuring longer-run trends is a difficult and delicate issue. Because expectations about monetary policy are important, particularly in financial markets, it may be useful for the FOMC to indicate what ranges are likely for the neutral federal funds rate. But given the uncertainties, this may be difficult and conveying a false sense of precision may prove to be counterproductive.

So, I believe, adjustments to the perceived neutral funds rate should be done with great care and discipline. They should not be done in response to the typical cyclical fluctuations in real rates. Our ability to truly assess a significant shift in the longer-term real rate is quite limited, and, in the presence of such uncertainty and measurement error, one should be careful not to confuse the public.

One has to bear in mind that monetary policy has to lead economic developments. Monetary policy is a bit like duck hunting. If you want to bag a mallard, you dont aim where the bird is at present, you aim ahead of its flight pattern. To me, the flight pattern of the economy is clearly toward increasing employment and inflation that will sooner than expected pierce through the tolerance level of 2 percent.

Some economists have argued that we should accept overshooting our 2 percent inflation target if it results in a lower unemployment rate. Or a more fulsome one as measured by participation in the employment pool or the duration of unemployment. They submit that we can always tighten policy ex post to bring down inflation once this has occurred.

I would remind them that Junes unemployment rate of 6.1 percent was not a result of a fall in the participation rate and that the median duration of unemployment has been declining. I would remind them, also, that monetary policy is unable to erase structural unemployment caused by skills mismatches or educational shortfalls. More critically, I would remind them of the asymmetry of the economic risks around full employment. The notion that we can always tighten if it turns out that the economy is stronger than we thought it would be or that weve overshot full employment is dangerous. Tightening monetary policy once we have pushed past sustainable capacity limits has almost always resulted in recession, the last thing we need in the aftermath of the crisis we have just suffered.

[I]ts important that federal fiscal policy gets done. But I dont believe that the Fed is, in the parlance of pop-psychology, an enabler of what most characterize as Washingtons intransigence on fiscal policy. This position argues that the Fed is somehow too reliable; that because we have the tools to manage a crisis, other institutions will avoid their own areas of responsibility because they can rely on us to pull an economic rabbit out of our hat. If theres no urgency, they can avoid action on politically volatile legislation, and the can gets kicked further and further down the road.

Let me be clear that us doing our jobs doesnt absolve anyone of the responsibility to do theirs. Decisions about taxes, spending, and entitlement programs will always collectively be a political third rail, and monetary policybe it accommodative or fully normalizedwont change that. The idea that the Feds propping up of the economy is letting Congress avoid decision-making doesnt hold; that implies that the only prompt to action would be an economy in freefall, something no one wants. Congress has many reasons to act on fiscal policynot least of which being a growing population and shifting demographics that will see the largest generation in our history moving into old ageand nothing we do to interest rates will alter that reality.

The enabling argument is largely driven by an underlying concern that the Fed has somehow lost its independence, or that its becoming too active a player in the economy. But nothing could be further from the truth. We hold our independence as sacrosanct, because its necessary for us to make the best policy decisions we can. If we step out of our assigned role, we could endanger that independence, and that would fundamentally alter our ability to do our jobs.

Although theres general consensus that the measures we took in the immediate wake of the crisis were necessary, critics of the Feds policies believe that weve been too accommodative since then, and that after 2010, we shouldve stepped back and let the economy move on its own. I often hear that the economys recovering, so why is the Fed still intervening? Or, in other words: enough is enough.

Ending accommodative policy prematurely would have been a major mistake. In 2010, the economy wasnt yet back on trackin fact, it had barely begun to recover. When we initiated the second round of asset purchases, or QE2, in November 2010, the unemployment rate was around 9 percentonly slightly down from its peak of 10 percent.

The latest round of asset purchasesor QE3was announced in September 2012, when the economy was better, but still well short of healthy. At around 8 percent, the unemployment rate had improved, but was still very high by historical standards, and inflation was running below the preferred 2 percent longer-term goal. In both situations, the very real danger of the recovery stalling and the economy slipping into a state of prolonged stagnation called for additional monetary stimulus.

When you break a leg, you dont just snap the pieces back into place; you leave the cast on until the bone heals. Otherwise, you risk doing even greater damage. And in this case, the economy wasnt ready to walk on its own. Not doing anything, or not doing enough, would just have led to more pain and the need to take even stronger measures down the road.

I was recently in Japan, which offers a real-life example. They shied away from sufficiently aggressive policy and the Japanese economy remained mired in deflationary stagnation for 20 years. Only now are they starting to put more forceful policies into place, and, happily, theyre workingbut those policies are much more forceful than they wouldve been had they been instituted 15 or 20 years ago. In keeping with the patient analogy, you can keep the cast on for a few weeks and let it heal, or you can go without and require extensive surgery later. So if we take the longer view, the Feds actions are in line with people who prefer a light policy touch: were essentially doing less now to avoid having to do more later.

I am aware that not everyone is a fan of the Fed or of accommodative policy. Im not deaf to criticism, and reasonable people disagree on policy all the time. But the bottom line is, it has worked. And the asterisk is that its not permanent. We wont raise interest rates for some time, which is the real marker of tightening policy. However, weve already considerably reduced the pace of our asset purchases, which will likely end this year. Were moving towards normalization, and as the economy continues to improve, well take off the cast; when its able to move on its own, well take away the walking stick. The events of the past several years demanded strong policy action, and we were right to take it. But it doesnt reflect a fundamental shift in our goals or strategy.

Like skiers, our ability to anticipate what is likely to be around the next turn will make the difference between a smooth run down the mountain or an unpleasant spill.

Given model uncertainty and data measurement problems, there are, of course, limitations to the use of a simple rule. The rule is basically intended to work well on average, but central banks look at many variables in determining policy. There inevitably will be times when economic developments fall outside the scope of our models and warrant unusual monetary policy action. Events such as 9/11, the Asian financial crisis, the collapse of Lehman Brothers, and the 1987 stock market crash may require departures from a simple rule. Having articulated a rule guiding policymaking in normal times, however, policymakers will be expected to explain the departures from the rule in these unusual circumstances. With a rule as a baseline, departures can be quantified and inform us how excessively tight or easy policy might be relative to normal. If the events are temporary, policymakers will have to explain how and when policy is likely to return to normal. Thus, a simple rule provides a valuable benchmark for assessing the appropriate stance of policy. That makes it a useful tool to enhance effective communication and transparency.

Central bank actions constitute monetary policy if they alter the quantity of its monetary liabilities, often referred to as high-powered money. Central bank actions constitute credit policy if they alter the composition of its portfolio — by lending, for example — but do not affect the outstanding amount of monetary liabilities.

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I’ll close with a reminder that establishing credible limits to central bank intervention in credit markets is critical to central banks’ core monetary policy mission. Entanglement in the distributional politics of credit allocation inevitably threatens the delicate equilibrium underlying central bank independence, which has been so essential to monetary stability. The fallout from the 2008 crisis vividly illustrates the risks to that equilibrium. The breakdown of that equilibrium in the 1970s provides vivid lessons in the dangers of credit allocation. Not only did Fed policymakers need to resist political pressure to lower unemployment, they also had their hands full resisting pressure to buy federal agency debt. The disastrous results for inflation are well known. Less well known is that by 1977, the Fed owned $117 million in debt issued by Washington, D.C.’s transit authority — with the bizarre result that the Fed wound up financing the construction of the Washington Metro.

In my view, the proper role for monetary policy is to work behind the scenes in limited and systematic ways to promote price stability and long-term growth. Since the onset of the financial crisis, central banks have become highly interventionist in their efforts to manipulate asset prices and financial markets in general as they attempt to fine-tune economic outcomes. This approach has continued well past the end of the financial crisis. While the motivations may be noble, we have created an environment in which "it is all about the Fed." Market participants focus entirely too much on how the central bank may tweak its policy, and central bankers have become too sensitive and desirous of managing prices in the financial world. I do not see this as a healthy symbiotic relationship for the long term.

If financial market participants believe that their success depends primarily on the next decisions of monetary policymakers rather than on economic fundamentals, our capital markets will not deliver the economic benefits they are capable of providing. And if central banks do not limit their interventionist strategies and focus on returning to more normal policymaking aimed at promoting price stability and long-term growth, then they will simply encourage the financial markets to ignore fundamentals and to focus instead on the next actions of the central bank.

I hope we can find a way to make monetary policy decision-making less interventionist, less discretionary, and more systematic. I believe our longer-term economic health will be the beneficiary.

Let me point out that the instructions from Congress call for the FOMC to stress the long run growth of money and credit commensurate with the economy's long run potential. There are many other things that Congress could have specified, but it chose not to do so. The act doesn't talk about managing short-term credit allocation across sectors; it doesn't mention inflating housing prices or other asset prices. It also doesn't mention reducing short-term fluctuations in employment.

Many discussions about the Feds mandate seem to forget the emphasis on the long run. The public, and perhaps even some within the Fed, have come to accept as an axiom that monetary policy can and should attempt to manage fluctuations in employment. Rather than simply set a monetary environment commensurate with the long run potential to increase production, these individuals seek policies that attempt to manage fluctuations in employment over the short run.

BERNANKE: Well, I think it's -- it's quite true that business confidence, home builder confidence, consumer confidence are -- are very important. And good policies promote confidence.

That's -- the Fed policy, congressional policy, we want to try to create a framework where people understand what's happening and -- and they believe they have confidence that -- that the basics of macroeconomic stability will be preserved.

It is a difficult thing, you know, to some extent it's a political talent to create confidence in -- in your constituents. So nobody has a magic formula for that. But, clearly, the more we can demonstrate that we're working together to try to solve these important problems, the more likely we're gonna instill confidence in the public. And that, in turn, will pay off in economic terms.