BERNANKE: Well, first, I think that many of the monetary or nominal indicators that somebody like Milton Friedman would look at did suggest the need for more monetary stimulus. For example, nominal GDP has grown very slowly. Growth in the money supply is a fact -- not talking about the reserves held by banks, which are basically idle, but if you look at M1 and M2, those have grown pretty slowly.
The Taylor rule suggests that we should be in some sense way below zero in our interest rate and therefore we need some method other than just normal interest rate changes to -- to...

TOOMEY: Do you know if Mr. Taylor believes that?

BERNANKE: Well, there are different versions of the Taylor rule. And there's no particular reason to pick the one he picked in 1993. In fact, he preferred a different one in 1999, which if you use that one gives you a much different answer.

TOOMEY: My understanding is that his view of his own rule is that it would call for a higher fed funds rate than what we have now.

BERNANKE: There are, again, many ways of looking at that rule, and I think that ones that look at history, ones that are justified by modeling analysis, many of them suggest that we are -- we should be well below zero, and I just would disagree that that's the only way to look at it. But, anyway, so I think there are some -- there is some basis for -- for -- for doing that.
I'm sorry, the last part of your question was?

TOOMEY: In the context of even, unfortunately, slow economic growth, should that persist, what kind of inflation indications would cause you...

BERNANKE: ... we are very -- we are -- we are committed -- you know, some -- some economists have -- a few economists have suggested temporarily raising inflation above normal levels in order to -- as a way of trying to stimulate the economy. We have rejected that approach, and we are committed to not letting inflation go above sort of the normal level of around 2 percent in the medium term.

So we are looking very carefully at indicators of inflation, including actual inflation, including commodity prices, including the spreads between nominal and index bonds, which is a measure of inflation compensation, looking at surveys, business pricing plans, household inflation expectations. We look at a whole variety of things.  And we -- I just want to assure you, we take the inflation issue very, very seriously, and we do not have the illusion that allowing inflation to get high is in any way a constructive thing to do. And we are not going to do that.

I can be reasonably certain of only one point: My economic forecast is highly likely to be wrong--but I don't know how. One implication of this pervasive uncertainty is that any statement about the future path of monetary policy must be conditional--dependent on the economy following the expected path. Although the FOMC has stated that the federal funds rate is likely to remain exceptionally low for an extended period, this statement explicitly depends on an economic outlook similar to the one I have given today. We cannot provide a precise timetable for when short-term interest rates will begin to return to normal because that depends on the evolution of actual and projected activity and inflation.

One implication of this pervasive uncertainty is that any statement about the future path of monetary policy must be conditional--dependent on the economy following the expected path. Although the FOMC has stated that the federal funds rate is likely to remain exceptionally low for an extended period, this statement explicitly depends on an economic outlook similar to the one I have given today. We cannot provide a precise timetable for when short-term interest rates will begin to return to normal because that depends on the evolution of actual and projected activity and inflation.

In my experience, these and other considerations put a premium on flexibility. The need to learn from and respond to news means that policy should have a substantial discretionary component. We have certainly needed to innovate over the past several years to contain the damage from unprecedented events in financial markets. But discretion has its limits as well. We must be able to explain and justify our actions within a coherent framework--even if the elements of that framework are adjusted from time to time as experience dictates. And to the extent that we can act predictably, households and businesses will be able to anticipate our actions, reinforcing their effects. Finally, we must not be flexible about our objectives. The goals of monetary policy--price stability and maximum employment--are stable and well known. The flexibility relates to the actions we take to get there.

I will try to define some of the important characteristics of asset price bubbles. I will argue that bubbles do exist and that bubbles typically occur after an innovation that has created uncertainty about fundamental valuations. This has two important implications. First, a bubble is difficult to discern and, second, each bubble has unique characteristics. This implies that a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.

It's important that our policy rule be robust enough to work in a variety of economic conditions or stages of the business cycle, that it perform well in a variety of economic models, and that it recognize that economic data are measured imprecisely and are subject to revision. These criteria lead me to support a rule based on deviations of inflation from the policymakers' inflation target and on the growth rate of output, rather than on the output gap commonly used in many variants of the well-known Taylor-rule.

Which version of the Taylor rule--the standard version, that uses current values of inflation, or the alternative version, that employs inflation forecasts--is the more reliable guide? I have explained my preference for using inflation forecasts rather than actual inflation in the policy rule: Monetary policy works with a lag, and therefore policy decisions must be forward looking. One might still prefer the simplicity of the standard Taylor rule that uses current inflation values. However, note from Slide 4 that a proponent of the standard rule would have recommended that the FOMC raise the policy rate to a range of 7 to 8 percent through the first three quarters of 2008, just after the recession peak and just before the intensification of the financial crisis in September and October--a policy decision that probably would not have garnered much support among monetary specialists. In contrast, Slide 4 shows that the version of the Taylor rule based on forecast inflation (in green dots) explains both the course of monetary policy earlier in the past decade as well as the decision not to respond aggressively to what did in fact turn out to be a temporary surge in inflation in 2008. This comparison suggests that the Taylor rule using forecast inflation is a more useful benchmark, both as a description of recent FOMC behavior and as a guide to appropriate policy.

During the last three decades, many central banks around the world have adapted to advances in the science of monetary policy. We have learned much from the experiences of those central banks that were early adopters of these advances. One theme that has emerged from this mix of academic research and experience is the important role played by the public's and market participants' expectations regarding policy actions. Uncertainty regarding policymakers' goals and the actions they will take to achieve them can make it more difficult to achieve those goals. Moreover, this uncertainty introduces unnecessary volatility into economic outcomes.

In normal times, we use our policy instrument, the short-term federal funds rate, to try to achieve our dual mandate goals of maximum sustainable employment and price stability. Adding a third target—asset prices—would likely mean we couldn't do as well on the other two.

Fortunately, I believe there is a way out of this dilemma: the Fed should adopt an explicit inflation objective and publicly commit to achieving that objective over some intermediate horizon. To me, the exact number or price index for the objective is somewhat less important than the public commitment to a goal. Such a commitment would help anchor expectations more firmly and diminish concerns of persistent inflation or persistent deflation — not an inconsequential issue in the current environment.

In addition to announcing an inflation objective, we must also clearly communicate our policy strategy to the public so that they understand how the FOMC anticipates achieving that goal. There are different ways to accomplish this. For example, Taylor-like rules that involve adjusting the federal funds rate in response to deviations of inflation from target and shocks to output or economic growth have some advantages. Such simple rules can be useful guides for conducting systematic policy and can help effectively communicate to the public the conditional nature of policy choices.

{The debate over rules and descretion} is always on our minds. And for me, in the present circumstance, it arises in how you calibrate your concern about growth. Real interest rates have to fall when growth slows, but you want to communicate that you're not using your discretion to just shift your attention from one objective to the other. It's important for people to know that we're maintaining a continual focus on inflation. It's just that the state of the real economy justifies lowered growth now. You don't want it to be interpreted as we're throwing inflation overboard for a few months while we worry about growth. So it's letting people know that we're following what we view as a time-consistent strategy to commit to keeping inflation low, and that we're not just acting on a purely discretionary basis.
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The Taylor Rule has proved incredibly useful as a very convenient way of summarizing algebraically and approximating in a fairly impressively good way, the way central banks behave. But keep in mind that Taylor Rule is a function of just things you can observe. Actual realized inflation recently. And what it leaves out are a lot of things policy makers can observe. What their forecast is, what's going on in oil markets, a lot of other data that go into our thinking, and that can affect our sense of how the economy's going to evolve. And those things, in turn, affect our policy setting. That doesn't mean we throw the Taylor Rule overboard. On the contrary. It's something that you want to deviate from only with good reason and only being very careful. And the farther you get away from it, the more you have to kind of check yourself as to whether you're really on solid ground or not.

I do believe, however, that lender-of-last resort policies should take a lesson from what we have learned from the theory of monetary policy. In particular, policy should have important rule-like features. Specifying in advance the conditions or states of the world under which the central bank will lend is an essential first step. But policy must also make credible commitments to act in a systematic way consistent with explicit ex-ante guidelines. Discretion in lending practices runs the risk of exacerbating moral hazard and encouraging financial institutions to take excessive amounts of risk. Nevertheless, the issue of trading off financial stability and moral hazard will likely remain. 

Beyond that, the central bank's historical role as a lender of last resort places it squarely in the center of financial disruptions as they unfold. We are perhaps not as close to a consensus on the proper conduct of this role as we are with regard to price stability. But as we continue to learn about the causes and nature of financial instability, I believe we should strive for policy that is informed by the lessons learned in the achievement of price stability. Chief among those is that a central bank can achieve better outcomes if it can establish credibility for a pattern of behavior consistent with achieving its long-term goals.

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.

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.

There's no textbook answer to what monetary policy should be doing at this time.

From Q&A as reported by Market News International and Bloomberg News