We don’t mean to suggest seriously that machine will replace human in monetary policy-making. But having such a system would have several advantages. First, like the automatic pilot in an airplane or an AI diagnostic system in medicine, an expert system for monetary policy would provide a useful information aggregator and benchmark for human decision-making. Second, because private forecasters or research institutes could replicate expert system results, such systems might enhance transparency and credibility of the central bank by providing objective information about forecasts and the implied policy settings.

Is there then no middle ground for policymakers between the inflexibility of ironclad rules and the instability of unfettered discretion? My thesis today is that there is such a middle ground--an approach that I will refer to as constrained discretion--and that it is fast becoming the standard approach to monetary policy around the world, including in the United States. As I will explain, constrained discretion is an approach that allows monetary policymakers considerable leeway in responding to economic shocks, financial disturbances, and other unforeseen developments. Importantly, however, this discretion of policymakers is constrained by a strong commitment to keeping inflation low and stable.

Certainly, globalization does mean that changes in foreign demand conditions matter more for U.S. aggregate demand. And global financial markets and cross-border capital flows quickly transmit pressures abroad to U.S. markets. But neither has had much effect on our ability to control domestic monetary policy. The reason is that there’s still a substantial “home bias” in our demand for goods, services, and assets—that is, the bulk of the goods and services we consume and the assets we hold are produced or issued in the U.S.

The Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero. Most central banks seem to understand the need for a buffer zone.

My suggested framework for Fed policy regarding asset-market instability can be summarized by the adage, Use the right tool for the job.

As you know, the Fed has two broad sets of responsibilities. First, the Fed has a mandate from the Congress to promote a healthy economy--specifically, maximum sustainable employment, stable prices, and moderate long-term interest rates. Second, since its founding the Fed has been entrusted with the responsibility of helping to ensure the stability of the financial system. The Fed likewise has two broad sets of policy tools: It makes monetary policy, which today we think of primarily in terms of the setting of the overnight interest rate, the federal funds rate. And, second, the Fed has a range of powers with respect to financial institutions, including rule-making powers, supervisory oversight, and a lender-of-last resort function made operational by the Fed's ability to lend through its discount window. By using the right tool for the job, I mean that, as a general rule, the Fed will do best by focusing its monetary policy instruments on achieving its macro goals--price stability and maximum sustainable employment--while using its regulatory, supervisory, and lender-of-last resort powers to help ensure financial stability.

From mid-1999 through May 2000, the federal funds rate was raised 150 basis points. However, equity price increases were largely undeterred during that period despite what now, in retrospect, was the exhausted tail of a bull market. Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion. Instead, we noted in the previously cited mid-1999 congressional testimony the need to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

The uncertainties surrounding the current economic situation are considerable, and, until we see more concrete evidence that the adjustments of inventories and capital spending are well along, the risks would seem to remain mostly tilted toward weakness in the economy. Still, the FOMC opted for a smaller policy move at our last meeting because we recognized that the effects of policy actions are felt with a lag, and, with our cumulative 2-3/4 percentage points of easing this year, we have moved a considerable distance in the direction of monetary stimulus. Certainly, should conditions warrant, we may need to ease further, but we must not lose sight of the prerequisite of longer-run price stability for realizing the economy's full growth potential over time.

The period of sub-par economic performance, however, is not yet over, and we are not free of the risk that economic weakness will be greater than currently anticipated, and require further policy response. That weakness could arise from softer demand abroad as well as from domestic developments. But we need also to be aware that our front-loaded policy actions this year coupled with the tax cuts under way should be increasingly affecting economic activity as the year progresses.

If the public is unclear about the strategy and objectives of the central bank, the credibility of monetary policy may suffer. Current economic developments or policy actions directed toward short-run concerns could have an outsized influence on perceptions regarding the more distant future--especially long-run inflation expectations and, therefore, long-term interest rates. Because such changes in perceptions could be counterproductive, concern about triggering them might discourage a central bank from taking action that otherwise could have been appropriate and beneficial for the economy in the near term. Lack of transparency and lack of credibility, in this sense, could reduce the effectiveness of monetary policy in stabilizing the economy against transitory shocks.

But what interest rates will be associated with a return to healthy growth in spending remains an open question. Incoming data have remained mixed, but on balance suggest that the economy has been expanding very slowly...All in all, I think it is too early to have a strong conviction that the economy is reaching the end of this period of quite slow growth. As the FOMC noted yesterday, the risks remain toward economic weakness.

Although the sources of long-term strength of our economy remain in place, excesses built up in 1999 and early 2000 have engendered a retrenchment that has yet to run its full course. This retrenchment has been prompt, in part because new technologies have enabled businesses to respond more rapidly to emerging excesses. Accordingly, to foster financial conditions conducive to the economy's realizing its long-term strengths, the Federal Reserve has quickened the pace of adjustment of its policy.

You once said, Mr. Chairman, that we always make one move too many.

If new data suggest it is likely that the pace of cost and price increases will be picking up, the Federal Reserve will have to act promptly and forcefully so as to preclude imbalances from arising that would only require a more disruptive adjustment later--one that could impair the expansion and bring into question whether the many gains already made can be sustained.

For monetary policy to foster maximum sustainable economic growth, it is useful to preempt forces of imbalance before they threaten economic stability. But this may not always be possible--the future at times can be too opaque to penetrate. When we can be preemptive, we should be, because modest preemptive actions can obviate more drastic actions at a later date that could destabilize the economy.

In the current circumstances, we need to be aware that monetary policy tightening actions in the United States could have outsized effects on very sensitive financial markets in Asia, a development that could have substantial adverse repercussions on U.S. financial markets and, over time, on our own economy. But while we must take account of such foreign interactions, we must be careful that our responses ultimately are consistent with a monetary policy aimed at optimal performance of the U.S. economy.