Central bank[s] must incorporate into [their] decisions the risks and consequences of several alternative outcomes. That is, [they need] to assess not only the most likely outcome for a particular course of action but also the probability of the unusual--the tail event. And [they need] to weigh the welfare costs of the possible occurrence of those tail events. This risk-management approach has been articulated by Chairman Greenspan for monetary policy, and it is equally applicable to a central bank’s decisions regarding crisis management.

Other instruments to deal with instability--discount window lending, moral suasion, actions to keep open or slowly wind down ailing financial institutions--are much more likely than monetary policy adjustments to have undesirable and distortionary effects on private behavior.

You want to move your policy towards neutral so you don't shoot through the [growth] trend line and ignite inflationary prices.  And that's the challenge of monetary policy as we go forward.

It is a world of intense competition, and that creates incentives to raise productivity as well as the means to do so. In the past decade, the U.S. economy’s average annual increase in output per hour has been 2.7 percent, just about equal to the extraordinary quarter-century boom that followed World War II. My business contacts talk and act as if the globalization now under way will bring another decade of hypercompetition. This global hothouse will enable, perhaps even force, businesses to keep productivity growth in the range we have enjoyed since the mid-1990s, hopefully for many years to come. If productivity growth can stay near 3 percent, monetary policy can accommodate relatively faster growth without igniting inflation.

As a general principle — that is to say, looking beyond the current tightening cycle — real interest rates must fluctuate as economic fundamentals change, even in the absence of visible perturbations in inflation prospects.

Monetary policy is capable of preventing oil price increases, or changes in the foreign exchange value of the dollar for that matter, from showing through to the underlying inflation rate.

Even if inflation remains low and constant, as we would like, we may still need to move the Fed funds rate fairly often.

Financial markets along with households and businesses seem to be reasonably well prepared to cope with a transition to a more neutral stance of monetary policy. Some risks necessarily attend this transition, but they are outweighed in our judgment by those that would be associated with maintaining the existing degree of monetary policy accommodation in the current environment.

The Federal Reserve Board strongly supports, as its key priorities for regulatory relief, legislative proposals that would authorize the payment of interest on demand deposits and on balances held by depository institutions at Reserve Banks, as well as increased flexibility in the setting of reserve requirements. We believe these steps would improve the efficiency of our financial sector, make a wider variety of interest-bearing accounts available to more bank customers, and better ensure the efficient conduct of monetary policy in the future.

As we have previously testified, unnecessary legal restrictions on the payment of interest on demand deposits at depository institutions and on balances held at Reserve Banks distort market prices and lead to economically wasteful efforts by depository institutions to circumvent these artificial limits. In addition, authorization of interest on all types of balances held at Reserve Banks would enhance the toolkit available for the continued efficient conduct of monetary policy. And the ability to pay interest on a variety of balances, together with increased authority to lower or even eliminate reserve requirements, could allow the Federal Reserve to reduce the regulatory and reporting burden on depository institutions of reserve requirements.

The first principle is that the FOMC will not respond to “shocks” that are seen as very transitory. Policy should only react to “shocks” that are longer lasting—highly persistent. The reason for this principle is quite straightforward—nothing that the FOMC can do will offset the impact on the economy of a “here today, gone tomorrow” event. While economists continue to debate exactly how “long and variable” the response of the economy is to a policy action, there is a consensus of professional opinion that it takes at least several months before the economy responds. Of course, judgment is always necessary to determine whether any particular shock is likely to be transitory.

Certainly, stability-enhancing changes in the economic environment have occurred in the past two decades. However, an intriguing possibility is that some of these changes, rather than being truly exogenous, may have been induced by improved monetary policies. That is, better monetary policies may have resulted in what appear to be (but only appear to be) favorable shifts in the economy's Taylor curve.

In my view, the most fundamental policy recommendation put forth by Milton Friedman is the injunction to policymakers to provide a stable monetary background for the economy. I take this to be a stronger statement than the Hippocratic injunction to avoid major disasters; rather, there is a positive argument here that monetary stability actively promotes efficiency and growth. (Hence Friedman's suggestion that the long-run Phillips curve, rather than vertical, might be positively sloped.) Also implicit in Friedman's focus on nominal stability is the view that central banks should avoid excessively ambitious attempts to manage the real economy, which in practice may exacerbate both nominal and real volatility. In Friedman's classic 1960 work, A Program for Monetary Stability, he suggested that monetary stability might be attained by literally keeping money stable: that is, by fixing the rate of growth of a specific monetary aggregate and forswearing the use of monetary policy to "fine-tune" the economy.

Allowing for known measurement biases, these inflation indexes have been in a neighborhood that corresponds to effective price stability--a long-held goal assigned to the Federal Reserve by the Congress. But we can pause at this achievement only for a moment, mindful that we face new challenges in maintaining price stability, specifically to prevent inflation from falling too low. This is one reason the FOMC has adopted a quite accommodative stance of policy. A very low inflation rate increases the risk that an adverse shock to the economy would be more difficult to counter effectively. Indeed, there is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral.

The FOMC stands ready to maintain a highly accommodative stance of policy for as long as it takes to achieve a return to satisfactory economic performance.