Toward the end of our lunch I asked, "What's it like to formulate monetary policy?"  [Bill Ford] thought for a moment and gave me a playful response. He said formulating monetary policy is like flying an airplane in low visibility conditions and choppy air. As the pilot, many times you see clouds and not much else. So you rely on your instruments, which are like economic data. The difficulty is half of the readings may be off, and you don't know which half at any given time.

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Twenty-five years ago Bill Ford equipped me with a useful metaphor of flying an airplane in low visibility as a way to think about my current responsibilities. Will the aircraft glide in for a soft landing? In my opinion, the answer is yes. I believe the current Fed policy abets a flight path of lower but still positive growth with moderate inflation. More turbulence may be ahead. So keep your seatbelts fastened.

If long-run expectations are in fact about 2 percent, where is actual inflation likely to be headed in the next year or two? While recognizing how embarrassingly wrong such prognostications often turn out to be, I think that we can be reasonably optimistic that core PCE inflation will gradually drift down from its latest twelve-month reading of 2-1/4 percent...

Looking to the medium term, I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy. For the most part, this assessment--which I should stress is subject to considerable uncertainty--flows from my view that long-term expectations appear to be well anchored at a level not very far below the current rate of inflation. If so, a substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming to bring about, as I noted earlier.

Still, given the probability of some tightness, we would need to see real GDP growth remain moderately below its long-run trend for a time to have confidence that the economy is heading for a soft landing with inflation continuing to move lower. The impetus for the needed moderate growth is likely already in train, given the cumulative effects of the 17 stepwise increases in the funds rate that began a couple of years ago.

...I believe that a soft landing is the most likely outcome over the next year or two.  However, I hope my remarks so far make it abundantly clear that there are sizeable risks to this forecast and that I am especially concerned about the upside risks to our inflation forecast. 

But since we’re not in Lake Wobegon, we can’t be above average all the time. Indeed, in the second quarter of last year, real GDP only grew at a 2.6 percent rate. In the third quarter, growth dropped to a 2.0 percent rate, and growth is likely to remain below average in the current quarter. Since growth clearly has slowed, the question on many people’s minds is, “What’s next?”

For some guidance, we can look back to similar episodes in the past. The long expansions of the 1980s and the 1990s resemble our current expansion in several key respects. Both were unusually long, by historical standards. Both saw substantial increases in production, employment and wealth. And in both cycles, there was a somewhat bumpy transition between an early, high-growth phase and a period of several years of more average, trend-like growth... [This] suggests that we should not be discouraged this time around by an uneven transition from rapid to more sustainable growth.

The aim of these {rate hikes}, to my mind, at least, was thus to set the economy on a glide path for the proverbial "soft landing"—an orderly slowing of growth that avoids the risk of a severe downturn while producing enough slack in labor and goods markets to relieve inflationary pressures and, indeed, to bring inflation down gradually to a more acceptable level than it has registered over the prior year or so.

In large measure, the economy has moved within range of this outcome.

In my view, however, what we are seeing in the recent information on factory output and capital spending is not the leading edge of general economic weakness but instead an adjustment to a sustained pace of expansion that, necessarily, is less rapid than that from mid-2003 to mid-2006...

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So, despite the recent favorable price data, I believe it is still too early to relax our concerns about whether the run-up in price pressures in the spring and summer of last year is truly unwinding and whether it is unwinding rapidly enough to forestall a pickup in inflation expectations.

Thus, as the year ended, the economy seemed to have completed that difficult down-shift in tempo, often referred to as a soft landing. On the inflation front, pressures seemed to ease a bit as November headline CPI grew at an annual pace just under 2 percent and core CPI was flat for the month. But for the 12-month period as a whole, core remained close to its third-quarter high, suggesting inflation may be slow to taper off.

I do not agree with pundits who argue about whether we can engineer a “soft landing.”  “Landing” implies stopping. I prefer to say that the Fed’s job is to provide the monetary conditions necessary to pilot our economy at a comfortable cruising altitude and speed while preventing the engine from overheating with inflation. As we look to 2007, I consider this objective to be within reach.

As slack in the economy is reduced, however, economic growth tends to moderate. Indeed, at that stage, some slowing of growth to a pace consistent with the rate of increase in the nation's underlying productive capacity is necessary if the expansion is to be sustained without a buildup in inflationary pressures. In my testimony to the Congress in July, as part of the Federal Reserve's semiannual monetary policy report, I noted that the U.S. economy had entered this transition phase, and that some moderation of economic growth over the remainder of the year seemed likely.

The deceleration in economic activity currently under way appears to be taking place roughly along the lines envisioned in the Federal Reserve's July report. As anticipated, the slowdown primarily reflects a cooling of the housing market. Most other sectors of the economy appear still to be expanding at a solid rate, and the labor market has tightened further.

Prices on federal funds futures and Eurodollar futures suggest that market participants expect the FOMC to cut the target federal funds rate about 50 basis points during 2007, a view consistent with expectations of a "soft landing." At the same time, market-based options prices on these interest rate futures indicate that implied volatilities are quite low, suggesting a surprising degree of certainty regarding policy expectations. Taken at face value, market participants appear to be reasonably certain of a benign outcome for both economic growth and inflation. In contrast, my own judgmental forecast includes a wider range of possible outcomes than is implicit in these market-based measures.

One potential pitfall in this {soft landing} argument is that, in the past, a noticeable and sustained shortfall of growth from its potential and an accompanying decrease in resource utilization have often cumulated into a full-fledged recession. Several features of the current financial situation, however, support my contention that "this time will be different." These recessions have often been triggered by a highly restrictive stance of policy and a generalized tightening of credit conditions through high long-term rates, wide risk spreads, and a pull-back of bank lending. Obviously, these conditions are not present today. Although one cannot rule out the possibility that a withdrawal from risk-taking could impinge on credit supplies and intensify downward pressure on activity, the preconditions for such a response do not seem to be in place. Business balance sheets are in very good shape and financial institutions are quite well capitalized.

I’m concerned with alternative D because, besides raising the rate to 5.50, it signals further increases. After seventeen consecutive moves, we would be tightening into a housing decline. We don’t have that much confidence that we need to be so strong at this point. Signaling a strong concern about inflation but being more cautious in groping for the optimal level of the interest rate is probably a wiser course. I remind you that the Fed has not been terribly successful with soft landings. We have a chance to get one. All else being equal, I think it would be good if we could achieve that.

Though economic activity hesitated in early 1995, it soon steadied, confirming the achievement of a historically elusive soft landing. The success of that period set up two powerful expectations that were to influence developments over the subsequent decade. One was the expectation that inflation could be controlled over the business cycle and that price stability was an achievable objective. The second expectation, in part a consequence of more stable inflation, was that overall economic volatility had been reduced and would likely remain lower than it had previously.

It is useful to distinguish two broad classes of hard landings. The first involves the reversal of an imbalance between aggregate supply and aggregate demand. The classic example is the boom-bust scenario. The second class involves the unwinding of sector or market imbalances that either initiate a downturn in the economy or aggravate a downturn that would otherwise have occurred. A classic example of this genre is a stock market correction...I associate many of the second class of hard landing scenarios with the work of a former colleague and friend, Hyman Minsky, who died in 1996. He emphasized the development of financial vulnerabilities in expansions and their contribution to serious recessions. In his view, serious recessions are typically the result of a coincidence of adverse shocks on an already vulnerable economy. Minsky emphasized the role of vulnerabilities arising from financial imbalances, including excessive debt burdens or increases in the price of risky assets relative to safe assets.