This analysis highlights three important insights for monetary policy under uncertainty. First, even in the presence of considerable uncertainty about the effects of monetary policy, the optimal policy nevertheless responds strongly to shocks: uncertainty does not imply inaction. Indeed, in the estimated model, the optimal conventional and unconventional policy responses in the current situation are quite strong, just not as strong as would be called for absent uncertainty. Second, one cannot simply look at point forecasts and judge whether policy is optimal or not. One needs to evaluate policy in the context of the distribution of forecasts that accounts for uncertainty. Indeed, once one recognizes uncertainty, some moderation in monetary policy may well be optimal. Third, in the context of multiple policy instruments, the optimal strategy is to rely on the instrument with the least uncertainty and use other, more uncertain instruments, only when the least uncertain instrument is employed to its fullest extent possible.

A long period of unusually low interest rates is changing investors’ behavior and is reshaping the products and the asset mix of financial institutions. Investors of all profiles are driven to reach for yield, which can create financial distortions if risk is masked or imperfectly measured, and can encourage risks to concentrate in unexpected corners of the economy and financial system. Companies and financial institutions, such as insurance companies and pension funds, and individual savers who traditionally invest in long-term safe assets, are facing challenges earning reasonable returns, and so they may reach for yield by taking on more risk and reallocating resources to earn higher returns. The push toward increased risk-taking is the intention of such policy, but the longer-term consequences are not well understood.

Of course, identifying financial imbalances, asset bubbles or looming crises is inherently difficult, as policymakers were painfully reminded during the financial crisis in 2008. Public transcripts of the FOMC’s discussions from as early as 2006 show participants were clearly focused on issues in the housing market and yet did not fully appreciate the risk to the economy from the financial sector’s exposure to risky mortgages.

Accordingly, I approach policy decisions with a healthy dose of humility when considering the long-run effects of monetary policy. We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances. Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels. A sharp correction in asset prices could be destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels.

Simply stated, financial stability is an essential component in achieving our longer-run goals for employment and stable growth in the economy and warrants our most serious attention.

Since September, hardly a trading day goes by without a company announcing a new debt offering to take advantage of today's historically low interest rates to finance further share buybacks and/or special dividend payouts. Too little of this money is being used to invest in job creation and job-creating expansion of plant and equipment in the U.S. Which raises a question about the efficacy of our accommodative monetary policy: Are our massive purchases of Treasury notes and bonds effective in meeting our mandate of conducting monetary policy so as to create maximum employment?

The answer is, quantitative easing is a necessary but insufficient tool to spark job creation. Employers will not deploy the cheap and abundant capital on hand toward job creation while there is so much uncertainty surrounding final demand for the goods and services they sell.

We have a ranch in Franklin County in East Texas. We have a 2,200-pound bull there that breeds our Longhorn cows. His name, incidentally, is "Too Big to Fail."

Now, Too Big has plenty of liquidity at his disposal; he's fully equipped to do what we want him to do. But if we put him on the opposite side of the fence from those pretty cows, he's unable to perform. Think of the uncertainty I've just spoken of, and especially the uncertainty surrounding the resolution of the fiscal cliff, as a fence. Businesses, just like Too Big, have plenty of liquidity; they have the resources they need to do what we want them to do—in this case, invest in job creation. But as long as that fence of uncertainty is in place, they will not be able to perform.

The final force I want to mention is the depressing effect on spending and investment caused by uncertainty. By almost any measure, uncertainty is high. Businesses are uncertain about the economic environment and the direction of economic policy. Households are uncertain about job prospects and future incomes. Political gridlock in Washington, D.C., and the crisis in Europe add to a sense of foreboding. I repeatedly hear from my business contacts that these uncertainties are prompting them to slow investment and hiring. As one of them put it, uncertainty is causing firms to “step back from the playing field.” Economists at the San Francisco Fed calculate that uncertainty has reduced consumer and business spending so much that it has potentially added a full percentage point to the unemployment rate.

In my judgment, our deployment of unconventional policy tools has been completely appropriate to help promote the Federal Reserve's statutory mandate of maximum employment and price stability. Ideally, monetary policy decisions would be informed by precise quantitative information about the effects of each tool. We do our best in this regard, and I can certainly attest that the FOMC reviews an enormous amount of information and analysis in reaching its decisions. That said, even in normal times, uncertainty is intrinsic to real-world monetary policymaking. Uncertainty about the effects of policy is particularly relevant under current circumstances where the scope for conventional monetary policy is constrained by the zero lower bound on the federal funds rate, leaving unconventional tools as the only means of providing further monetary accommodation.

As always, monetary policy will need to evolve in response to ongoing shocks and new information. But I suspect that information about aggregate labor market quantities like unemployment will remain—at best—a noisy indicator about the appropriate stance of policy. Instead, I will be paying close attention to the behavior of core inflation. As the preceding analysis suggests, the changes in this variable appear to provide critical information about the empirical relevance of nominal rigidities, and therefore about the appropriate stance of monetary policy

The drag of uncertainty on economic activity persists as we enter 2011. That said, I would argue that the pall of uncertainty has lifted somewhat, and improved visibility could encourage more business risk taking and consumer spending.

HENSARLING: My last quote and my first question, quote, "Uncertainty is seen to retard investment independently of considerations of risk or expected return. The introduction of uncertainty can be associated with slack investment, resolution of uncertainty with an investment boom." You know who wrote those words, and, yes, it is a trick question.

BERNANKE: I'm sure it was I who wrote those words. That was my -- it should have been, anyway, since that was my 1979 Ph.D. thesis was on uncertainty in investments. Maybe it wasn't me. I don't know.

HENSARLING: My notes here said 1980, but it's a very good memory, Mr. Chairman. Do you agree or disagree with yourself?

BERNANKE: Personally, I think that was an excellent thesis.

From the Q&A session

[U]ncertainty, even in good times, I think can be harder on you than certainty in bad times.

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.

A number of firms have learned hard, but valuable, lessons from the current crisis that they are applying to their internal processes to assess capital adequacy. These lessons include the linkages between liquidity risk and capital adequacy, the dangers of latent risk concentrations, the value of rigorous stress testing, the importance of strong governance over their processes, and the importance of strong fundamental risk identification and risk measurement to the assessment of capital adequacy. Perhaps one of the most important conclusions to be drawn is that all assessments of capital adequacy have elements of uncertainty because of their inherent assumptions, limitations, and shortcomings. Addressing this uncertainty is one among several reasons that firms should retain substantial capital cushions.

Uncertainty about the course of the economy is a lot lower than it was just a few short months ago. But we cannot lose sight that this uncertainty remains quite high; we are still in largely uncharted waters when it comes to fully understanding how our economy will recover from the severe recession and financial disruptions of the past several years and how that recovery and inflation will be affected by the extraordinary actions we took. We need to base policy on our best estimate of the evolution of inflation and output relative to our objectives, but we also need to be ready to adjust our plans if events don't turn out as predicted in either direction. We have the tools to exit our unusual policies when the time comes. And we must act well before demand pressures or inflation expectations threaten price stability.

I want to make a few more general comments on changes, actual or potential, in credit markets. These remarks are prompted in part by the conversations I often have with bankers, business people, and consumers. During these discussions I have realized that just about everyone understands we will never return to the credit markets of the middle part of this decade, but very few people believe they understand what the "new normal" will look like once the crisis has fully passed and the economy is on a sustained recovery path. I suspect that this uncertainty is itself an impediment to stronger growth, since it makes financial planning more difficult.

The loss of confidence we have seen in some banking institutions has arisen not only because market participants expect the future loss rates on many banking assets to be high, but because they also perceive the range of uncertainty surrounding estimated loss rates as being unusually wide. The capital assessment program was designed to reduce this uncertainty by conducting a stringent, forward-looking assessment of prospective losses at major banking organizations.