What about the role of the federal funds rate when the real economy is performing smartly but financial markets are functioning with exceptionally low volatility, and liquidity and credit spreads are extremely narrow? In these periods, the relationship between the federal funds rate and real activity is more difficult to decipher. If abundant credit availability is perpetuated by investor overconfidence, I would submit, policymakers may need to target a higher federal funds rate than otherwise to help the economy attain a sustainable equilibrium. That is, a federal funds rate that is satisfactory in times of normal market functioning may turn out be lower than required to ensure that the economy performs at potential through the horizon. Making that judgment represents an important, but difficult task for policymakers.

And how about when the real economy is operating below-trend in large part because financial markets are impaired, many financial intermediaries are undercapitalized, and risk and liquidity premiums are large and especially volatile? What happens when banks and other financial institutions that stand between the Fed and the real economy restrict the supply of credit beyond that implied by higher premiums or, potentially, economic fundamentals? Should markedly higher doses of monetary medicine (read: lower rates) be proffered to compensate fully for the reduced efficacy of the transmission channels?

Financial turmoil lowers real activity expected to accompany a given level of the federal funds rate. Such a development is equivalent to a fall in the neutral rate. But policymakers should recognize that financial market turmoil is not a garden-variety shock to output. It is different than, say, a demand shock caused by a change in exports. Financial market turmoil can lower output growth and limit the efficacy of the transmission mechanism concurrently. The federal funds rate, I maintain, will generally need to be lowered, and by more than in normal circumstances, to achieve an operative monetary policy rate that helps to restore the economy expeditiously to equilibrium. But policymakers need to think carefully about two issues: the degree of reduction in the federal funds rate and the pace at which the rate returns to normal.

The wisdom of emphasizing a forward-looking strategy over the Taylor rule approach may depend in part on policymakers' forecasting acumen. To estimate the neutral rate, central bankers must forecast how the forces affecting aggregate demand and supply will reconcile during the forecast period. Moreover, policymakers must project how changes in the federal funds rate--past and anticipated--will interact with asset prices, credit provision, and real-side variables. Under the best of circumstances, these forecasts are subject to meaningful uncertainty. Thus, peering into the future and acting on what we think we see will invariably lead to some mistakes, certainly with the benefit of hindsight. Ignoring the future altogether, however, hardly seems the wisest course.

Moreover, the Taylor rule approach does not remove uncertainty.

Consistent with Munger's admonition, the Fed saw it necessary to expand our toolkit beyond the proverbial hammer of the policy rate in the last nine months. And as I discussed in remarks last month, the Fed's nontraditional policy response included the use of innovative liquidity tools to counter the market turmoil and improve the functioning of financial and credit markets.⁴

In my remarks today, I would like to discuss the use of the hammer--the setting of the federal funds rate--particularly in extraordinary times. Of course, determining the proper level of the federal funds rate is rarely simple, given typical imprecision on key economic variables and relationships. It is far more challenging still when the financial architecture is in the early stages of redesign, the economy is adjusting to the aftermath of a credit bubble (witnessed most acutely in the housing markets), and inflation risks are evident.

The Federal Reserve has employed the hammer with considerable force in the last nine months, lowering the federal funds rate by 3-1/4 percentage points, with wide-ranging implications for the economy. Of substantial import, we have filled the toolkit with other implements to provide liquidity and improve the provisioning of credit during the turmoil. But now, policymakers may be well served encouraging a new financial architecture to emerge, aided, in part, by the actions we have taken. Even if the economy were to weaken somewhat further, we should be inclined to resist expected, reflexive calls to trot out the hammer again.

Policy actions should reinforce the notion with stakeholders that further hammering needs to be done, but it needs to be accomplished by the financial institutions themselves in retooling their businesses and rebuilding the credit channel to help ensure a stronger, more durable economy.

Munger, the proud non-economist, recounts another lesson born of his investment career that I find particularly heartening in considering the calculation of the neutral rate: Avoid the error of false precision.⁸ Most monetary policy frameworks, while fiercely debated in the academy, tend to suffer from a common and unavoidable weakness--relying on provisional estimates in a complex and uncertain world. This weakness argues in favor of being persistently inquisitive in search of a keener understanding of the economy. This consideration applies to the making of monetary policy in normal times; in times of turmoil, the case for humility is stronger.

The Taylor rule provides a convenient rule-of-thumb for setting monetary policy.⁶  The rule posits that the appropriate setting of the real federal funds rate incorporates three components. The first component is the economy's natural rate of interest. This is the real federal funds rate consistent with output equal to potential, on average, over the medium- to long-run. If policymakers set the real federal funds rate at this level, the Fed would be neither artificially boosting nor restricting the real economy over long periods. Holding the federal funds rate at the natural rate, however, may yield an undesirably slow return of real activity to normal, particularly if shocks have a persistent effect on aggregate demand and supply.

To expedite the process, the Taylor rule adds a second component to the real federal funds rate, one that purports to be proportional to the size of the current output gap. By setting the real federal funds rate below the natural rate when resource utilization is loose--and, correspondingly, above the natural rate when resource utilization is tight--policy purports to help move the real economy back to normal at a speedier pace. The third component responds to the gap between actual inflation and its desired rate, pushing real rates up when inflation is too high and pushing rates down when inflation is too low.

The Taylor rule provides a reasonable description of actual monetary policy behavior on average over the past 20 years. The reasonably good macroeconomic performance of this period suggests that central banks should pay some heed to its prescriptions. By design, however, the Taylor rule focuses largely on what can be observed in real-time, without accounting for some factors that influence monetary policy.

With the information now in hand, it is my judgment that monetary policy appears to be appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term. But a large measure of uncertainty surrounds that judgment and as the economy evolves, so will the appropriate stance of policy.  

To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.

The rise in commodity prices presents particular challenges for monetary policy because such increases both add to near-term inflationary pressures and damp demand. A tendency for increases in commodity prices to become a factor in ongoing pricing and wage-setting more generally would be a worrisome development that would over time tend to undermine economic welfare.

My expectations for moderating inflation and limited spillover effects from commodity price increases depend critically on the continued stability of inflation expectations. In that regard, year-ahead inflation expectations of households have increased this year in response to the jump in headline inflation. Of greater concern, some measures of longer-term inflation expectations appear to have edged up. If longer-term inflation expectations were to become unmoored--whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought--then I believe that we would be facing a more serious situation.

The Federal Open Market Committee will be monitoring inflation developments closely for any sign that our longer-run objective of promoting price stability is threatened.

We have had this financial crisis; I think on balance as we at the Federal Reserve have provided liquidity to the marketplace, it's my thought that we have stabilized things.

This allows the other policy choices, the tax cut ... monetary policy that's in place, to strengthen the economy as it goes through the course of the year. And in that context then, our big challenge will be to make sure that we bring inflation in check and make sure that we do not repeat some of the experiences we had in the late 70s and early 80s when inflation became far too high.

As reported by Reuters.

I consider the current level of monetary accommodation to be appropriate. That, together with the fiscal package, should be sufficient to promote a gradual step up to moderate economic growth later this year. Likewise, I would expect that inflation will moderate in coming quarters, as more slack in labor and product markets emerges and as commodity prices level off.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote growth over time and to mitigate risks to economic activity. I know that some observers are saying that this strategy introduces other risks. For example, some individuals question whether by lowering our policy rate in the face of price pressures, we put at risk our goal of keeping inflation low and stable over the long term.

While even the core price measures in the United States are rising somewhat faster than I would prefer, and inflation presents a key risk to my outlook, I believe that the Federal Reserve’s policy strategy remains compatible with a low and stable inflation rate.

[T]here are reasons that suggest the economic slowdown will be short-lived. Part of the pickup in growth will likely come from the tax cuts that are going into effect currently, part from the monetary policy stimulus provided by low interest rates and part from a boost to exports from the lower dollar. Forecasters also see moderation in energy and food costs later this year, which would provide a boost to growth but also lead to lower inflation pressures.

As I indicated earlier, we are also seeing signs of stabilization in financial markets, with improved liquidity and more transactions. Still, many markets are not functioning normally, and it will take additional time for the damage to be assessed and repaired.

As to monetary policy, the current accommodative stance should be sufficient to cushion the economy from a deeper slowdown and the risks that financial disruptions could spill over to the broader economy. As the economy recovers and credit conditions improve, however, it will be necessary for the Federal Reserve to remove the policy accommodation in a timely manner. How fast this occurs will depend on whether inflation pressures moderate or intensify in the period ahead.

My recommendation is that you take it [the April 30 FOMC statement] at face value. There are risks on both sides. There are tail risks, as the economists like to call them, on both sides.

We're in the business of risk management in that sense. We have a dual mandate. We have to (monitor) growth and inflation. The readers can study our entrails all they want. That's what makes it interesting. It says what it says, and that's all I'm going to say.

Personally, for me to change course, given that I stopped (supporting rate cuts) at 3 1/2 percent, I'd have to see a very dramatic economic slowdown going on beyond what I'm already discounting.

I'm already discounting significant anemia,