The use of neutral real rates in the formulation of monetary policy is not necessarily straightforward.  For instance, in some circumstances, attaining a "neutral" federal funds rate would in principle be an appropriate objective for monetary policy, but in others -- particularly when inflation is too high or too low -- aiming for a neutral funds rate in the near term would not be appropriate.  These uncertainties and complications suggest that reliance on a single summary measure such as a neutral real interest rate would be unwise as a strategy for formulating monetary policy.  Rather, a full consideration of current and prospective economic developments, and of the risks to the outlook, is essential for the conduct of monetary policy.

Greater transparency with regard to Federal Reserve actions encourages public discussion and informed scrutiny, important aspects of accountability in a democratic society.  Transparency also enables financial markets to better predict monetary policy decisions, which can contribute to improved policy outcomes.  However, providing more complete information about policy decisions is not without cost.  Transparency requires careful attention by policymakers, and so constrains the time they have for actually making decisions.  More importantly, excessive transparency could inhibit policymakers, making them less spontaneous in their remarks and less willing to explore new ideas.  Such an outcome would have adverse effects on policy decisions.  The Federal Reserve's current practices strike a reasonable balance between transparency and the degree of confidentiality appropriate to support the policy process.

I want to note that our recent post-FOMC meeting statements came with a caveat that reads: “The Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.” To me, this language means that while we’re working to gradually remove the remaining policy accommodation in this time of elevated inflation risks, we also must watch carefully for unexpected developments in the economy, especially how individuals and businesses respond to the continuing rise in energy costs.

[In the post-Greenspan era] Policy will less often be reacting to fluctuations in actual or expected inflation, and will more often be realigning real interest rates in response to changing economic fundamentals.

Hurricanes are obviously the very embodiments of unexpected developments...   Economic activity and prices will be affected for some time and discerning underlying trends will be difficult.  It is not obvious that this form of uncertainty has implications for monetary policy, however.  Pausing or slowing down a rise in policy interest rates would not itself help to reduce uncertainty because the way in which policy might affect spending or inflation is not in question.  Rather this is a situation in which a central bank generally is well advised to make its best forecast, to evaluate the risks around that forecast as well as it can, and to act on that forecast and associated evaluation of risks.

As our September FOMC meeting followed Hurricane Katrina by approximately three weeks and was held concurrently with the formation of Hurricane Rita, I felt that there was insufficient information as well as great uncertainty about how these forces would play out in the near term. As a result, I voted to pause in the removal of policy accommodation until more was known.

Despite the uncertainties that exist, I believe that these unfortunate events [Hurricanes Katrina and Rita] do not pose a persistent threat to national economic activity.  My overall assessment is that the national economy, while not without challenges, is in reasonably good shape and that conditions should allow for solid growth in the future.  In context, I believe that the Federal Reserve should continue to focus on having a neutral monetary policy which reflects its commitment to price stability.

The concern is that in an environment in which monetary policy has been accommodative, the joint effect of several inflationary pressures could erode price stability.  The FOMC will need to be alert and diligent as it works to maintain future price stability.

In the case of the hurricanes, the largest impact is likely to be of a regional nature: the need to rebuild businesses, homes, and infrastructures along the affected Gulf Coast regions.  If monetary policy was redirected to provide more accommodation to the rebuilding efforts, such policy could lead to excessive stimulus in the rest of the country.  The overall result would likely be an economic boom and rising inflation.

A negative supply shock leads to higher prices and decreased demand for goods and services.  As we have learned from the experience of the 1970s, a more accommodative monetary policy that attempts to offset decreased demaing during a negative supply shock leads to higher inflation that can be very costly to remove in the future.

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.

Given the positive momentum of the economy, it is much less likely that a regional shock will have an overall negative impact.  And should additional policy accommodation be added, there is a much greater chance that the economy will overheat and result in strong inflationary pressures.

It is also clear that monetary policy's capabilities are limited.  We may be able to limit the severity of the cycle, but we cannot eliminate it.  There are too many powerful forces at work in the economy for that.  And as the recent hurricanes remind us, an aggregate demand management tool is not very effective when the economy is hit with a shock from the supply side.

We must keep in mind that with expansions inevitably come increasing inflationary pressures.  In the near term, overall inflation will be affected by the substantial increase in energy prices.  To keep cyclical price pressures and any transitory spike in energy prices from permanently disrupting the price environment, the Fed will have to continue shifting monetary policy from its current somewhat accommodative stance to a more neutral one.

Despite their historical importance for aggregate inflation, energy prices, for example are controlled for in only one of the structural [inflation] models discussed at this conference.  And this importance is not necessarily a concern of the past: Prices for oil and natural gas have soared since 2003, directly boosting the energy component of the consumer price index as well as raising the production costs, and ultimately to at least some degree the prices, of non-energy goods and services.  As a policymaker, I can assure you that any model of inflation that did not take account of these effects, and how they might or might not affect ongoing rates of inflation, would have been or little practical use to the FOMC over the past few years.