You cannot have the dynamic progress Tom Friedman describes in his book without the well-functioning, reliable monetary regimes central banks have been sustaining. It is an especially intense responsibility for the Federal Reserve, as the primus inter pares central bank, serving the largest economy in the world and circulating the world’s most utilized currency. One cannot make monetary policy at the Federal Reserve without being cognizant of the forces of globalization acting upon our economy. Nor can one be oblivious to the need to conduct our policy with an awareness of how our actions impact markets and, therefore, economic potential worldwide. Keeping inflation in check is a central bank’s sacred mission. By spurring productivity and fomenting tectonic economic changes, globalization has acted as a tailwind for the Fed’s—and other central banks’—efforts to hold down inflation. I believe the Federal Reserve has been able to contain inflation with faster growth than would have been possible in the absence of globalization. In short, globalization has made the Fed’s job easier over the past few years.

Differences between how economic fundamentals are expected to unfold and how they actually unfold can have important implications for real interest rates and thus for monetary policy. As I have emphasized elsewhere, a real interest rate is a relative price — the price of current resources relative to the future resources one either forgoes by borrowing or obtains by investing. Real interest rates need to respond to changes in the relative pressure on current versus future resources. Unpredicted movements in economic fundamentals, to the extent that they affect the relative pressure on current and future resources, thus will have implications for policy rates, even in situations in which inflation and inflation expectations are low and well-contained.

Immediately following Hurricane Katrina, as the magnitude of the effects on Gulf Coast energy production became clear, many observers came to fear that the resulting sharp increase in energy prices might lead to a broader increase in inflation, and perhaps even recessionary forces. These observers appeared to be reasoning by analogy to the 1970s, but I believe that analogy is mistaken. Inflation expectations were unanchored in the 1970s, the credibility of the Federal Reserve was low, and people expected the Fed to allow energy price shocks to feed through to overall inflation. The Fed often accommodated that expectation by preventing short-term real interest rates from rising. In fact, at times we kept nominal rates from rising as fast as inflation and thus provided further monetary stimulus. The Fed was then forced to raise rates dramatically to bring inflation back down, and in the process induced an economic contraction, exacerbating the real effects of the oil price shocks. Thus, the proper lesson from the 1970s is not that energy price shocks induce major recessions or cause widespread inflation; it is that monetary policy that reacts to energy price shocks by accommodating the rise in inflation can induce major recessions. Monetary policy should respond to energy shocks by remaining focused on price stability. That way, the economy can respond to energy price shocks the way it should — the relative price of energy increases, but core inflation remains anchored.

Thus far, market participants appear to believe that core inflation will remain contained. Survey measures of expected inflation rose sharply in September when retail gasoline prices reached their peak, but have come back down since. Measures of expected inflation derived from market prices of inflation-protected U.S. Treasury securities drifted up a bit this fall, but they too have returned to mid-summer levels. To maintain credibility for price stability, it is essential that monetary policy should respond vigorously to any visible erosion in inflation expectations.

It is the duty of the Fed to refrain from the slightest temptation to monetize deficits or embrace any other inflationary policy,  In the Volcker and Greenspan eras, the Fed has done quite well in this regard, and it can be expected to continue countering inflationary pressures should they arise.

Coddling inflation by monetizing deficits is not an option in a globalized world.  It would erode our currency's value and undermine our economy's potential to grow and create jobs.  The solution to the problems laid out by the participants in today's conference rests squarely in the hands of our politicians, not with the central bank.

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.

Inflation expecations have become "well anchored" to price stability--most likely because people are confident that the Fed will act to limit any potential rise in inflation.  This may account for research results suggesting that, during this period, energy price increases have generally not been passed through to core inflation.

Historically, the Federal Reserve has not provided forward guidance for fear that it would lock itself into a policy stance that might, under new information, no longer be appropriate. In principle, there is no reason why the Fed cannot explain the nature of the conditionality and convey the view that policy guidance depends on information available at the time guidance is offered.

Under Chairman Greenspan, talk and action were combined to ensure the markets that over a period of time -- not necessarily within a quarter or two-quarters, but over a period of time, perhaps lasting several years, the Fed would ensure that inflation was stabilized in a region that was consistent with the objective of price stability.
So that is the approach I would take. I would certainly not try to return inflation to a target within a short period of time. I would simply try to assure the markets that over a long period of time that the Federal Reserve was committed to price stability as a central part of its monetary strategy.

Transparency has an important role in helping the public understand policy intentions and policy goals. However, transparency should not be allowed to interfere with the decision-making process itself...One extreme form of transparency would be simply to televise the meeting at which the discussion takes place. My concern about that suggestion is that it would inhibit discussion, that it would affect the decision process, that it would create volatility in financial markets. 

There's no perfect forecaster, no perfect indicator of inflation...Exchange rates reflect inflation pressures. They may also reflect the balance of trade and other factors. So there's no single optimal indicator of inflation. My personal strategy, therefore, is to be very eclectic and to look at a wide range of indicators. And among those is commodities, gold, exchange rates, the whole list. I think interest rates, real- side indicators, surveys, expectations, there's a whole list of variables which can be useful in forecasting inflation. And I think one has to be very open minded about using whatever information one has.

Natural gas prices have been rising for some time. And it's proved a very heavy burden to chemical manufacturers, alumina, other manufacturers in the United States. That's a real problem. I don't want to understate that problem at all. But...monetary policy...can only try to avoid having those price increases spread into general inflation. Monetary policy can't create more energy. It can't really solve the energy problem.

Monetary policy is most effective when it is as coherent, consistent, and predictable as possible, while at all times leaving full scope for flexibility and the use of judgment as conditions may require.

Although the concept of a "neutral interest rate" is a useful theoretical construct, difficulties in implementing it in practice limit its usefulness as a framework for monetary policymaking.  For one thing, a variety of definitions of a neutral real interest rate are possible.  For another, quantitative estimates of the level of such a rate are subject to considerable uncertainty.  Also, such estimates can vary widely depending on the type of measure and the prevailing and projected economic conditions.  In particular, all variables that contribute to making a macroeconomic forecast are relevant for estimates of neutral interest rates, greatly complicating such assessments.  Thus, it is impossible to know with any certainty when the neutral rate has been reached.