Headline and core inflation have come in higher than anticipated, and inflation expectations have also moved up. If the risk of significant damage to growth from these financial market pressures is attenuated and if global growth remains strong and drives a continuing rise in energy and commodity prices, then inflation may not moderate as much as we anticipate. If the medium term outlook for inflation deteriorates significantly, the FOMC will move with appropriate speed and force to address this risk.

Because credit contractions can emerge and spread rather quickly, the central bank must be prepared to act in an aggressive and timely manner to counteract their effects. And indeed, the Federal Reserve's policy actions since last August have been designed to ease the strains in financial markets and to counteract a projected weakening in economic activity.

So a key assumption underlying my 2008 projections is that economic activity is, in fact, highly vulnerable to a significant credit crunch. Because credit crunches can restrain economic activity through channels that are not fully captured by econometric models or historical experience, my forecast builds in a slower growth trajectory for consumer spending, residential investment, and non-residential investment than the model would have called for otherwise. These adjustments, of course, are only an educated judgment. A credit crunch could impose even more restraint on economic activity, presenting a downside risk to my baseline projection.

The current economic environment does have some extraordinary features, namely the tremendous difficulties that are affecting the smooth working of capital markets. Some interest rate spreads remain high, and financial capital has taken serious hits at a number of institutions. Thus, I believe we are in a situation where monetary policy cannot be made by focusing solely on inflation and deviations of output from potential. The current turmoil in financial markets has already had a significant impact on the economy and has the potential to continue to restrain economic growth going forward

One important desirable feature of simple interest rate rules such as Taylor’s is – it is a rule. That is, it systematically describes the behavior of policy. The advantages of simple rules are many. First, they are transparent, and allow for simple and effective communication of policy decisions. The result is that policymakers can more easily be held accountable and it is easy for the public and financial market participants to form expectations about policy. Thus, relying on simple rules enhances the credibility of monetary policy and helps anchor expectations. Second, when rules are simple and transparent, the public’s expectations are easily aligned with the Fed’s intentions, which minimize policy surprises and the detrimental effects often caused by such surprises. Thus, I place significant importance on systematic behavior both as a prescription for good policy and in terms of my own policy deliberations.

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The benefits of operating in an environment with the transparency afforded by simple rules is that it gives monetary policymakers the ability to anchor expectations and affords them the opportunity to temporarily deviate from the simple rules in extraordinary circumstances without eroding central bank credibility. We are now, perhaps, in a period of extraordinary circumstances and have deviated from the benchmarks suggested by simple rules. But such deviations should be temporary and limited and promptly reversed when conditions return to normal.

[L]ower rates are likely to result in higher house prices than would occur in the absence of monetary easing. This should reduce the foreclosure rate and reduce some of the concern that housing problems will become more widespread. Finally, lower rates should result in less unemployment – one of the main drivers in forced sales of houses. Thus, monetary policy actions may significantly reduce the depth of problems, but are of course not a panacea.  

One critical precondition for effective central-bank easing in response to adverse demand shocks is anchored long-run inflation expectations. Otherwise, lowering short-term interest rates could raise inflation expectations, which might lead to higher, rather than lower, long-term interest rates, thereby depriving monetary policy of one of its key transmission channels for stimulating the economy.

Being a dissenter -- it's not like in politics where it's some awful negative thing. All of us are responsible and take very seriously the duties of inflation management.

From press Q&A as reported by Market News International.

In present circumstances, monetary policymakers will need to be careful to react to evidence on the state of the economy and likely outlook for employment. The issue is likely developments in the labor market and not merely possible developments. At the same time, policymakers will have to remain conscious of the lessons of history with regard to inflation. Here again, likely developments and not just possible developments must be the focus of attention. Risk mitigation to counter costly possible developments is an important strategy, but taking out insurance against certain risks is not free.

You've got an industry here that's in depression ... But we have to be careful that we have monetary policy that is for the entire economy. We can't allow 5% of the economy to so dominate the monetary policy outcome that we forget about the other 95% of the economy.

From audience Q&A, when asked about the housing and residential construction downturn, as reported by Market News International

I think the Federal Reserve has taken appropriate policy steps to respond to a financial shock, a shock that may well produce parallels to the headwinds episode of the early 1990s. In this environment, we need to remain sensitive to evolving financial conditions and to incoming information on business activity in order to further determine the relevance of that earlier experience. And the aftermath of that episode may also prove relevant, in that it illustrates the underlying resilience of the American economy and the value of policy adherence to the dual mandate.

Its always hard to know how much to do and when. That's not to say we're doomed to get it wrong or partially wrong, but it's not easy to get it right. The economy is sound and flexible and resilient underneath it all, so monetary policy doesn't have to be exactly precisely correct month by month for the economy to do well.

From press Q&A as reported by Market News International

To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible. ... [I]n my view, the Federal Reserve's recent monetary policy actions--reducing the target federal funds rate by 1 percentage point last fall and by a further 1-1/4 percentage points in January--have been consistent with these principles for coping with macroeconomic risk.    

I believe that the Federal Reserve has been acting and will continue to act decisively, in the sense that our lowering of the federal funds rate target has reflected the evolution of the balance of risks to the macroeconomy. The disruption in financial markets poses a substantial downside risk to the outlook for economic growth, and adverse economic or financial news has the potential to cause further strains. In that light, the Federal Reserve's policy strategy is aimed at providing adequate insurance to help mitigate the risk of more-severe macroeconomic outcomes.

Greater caution on the part of businesses and consumers will likely limit increases in their discretionary expenditures. And the strains on credit intermediation and financial balance sheets will likely hold down growth to a degree for some time. Since these financial issues are being worked out against the backdrop of a soft economy, we also have to recognize the risk that interactions between the two might reinforce the weakness in the economy.

In response to these downside influences, and with inflation expectations contained, I believe a relatively accommodative monetary policy is appropriate. At 3 percent, the current federal funds rate is relatively accommodative and should support stronger growth. Indeed, because monetary policy works with a lag, the effects of last fall's rate cuts are probably just being felt, while the cumulative declines should do more to promote growth as we move through the year.

In addition, the fiscal stimulus bill the President signed yesterday will likely boost spending in the second half of the year.

A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability and, in particular, whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation, as well as the risks to that forecast.