The issue of expectations illustrates our ignorance.  As I have already indicated, inflation expectations are among the most important variables policymakers monitor, but we do not have answers to our most basic questions about them:  Are available measures suitable indicators of true inflation expectations by households and businesses?  How are expectations formed--and in particular what are the respective roles of central bank talk, central bank actions, and actual inflation outcomes?  And how do expectations influence price and wage setting?  In short, although I believe that inflation expectations are critical to assessing the inflation outlook, I cannot be sure (particularly in real time) that our expectational measures are accurate and so cannot know what precise role expectations play in wage and price dynamics.  

But there is uncertainty and then there is uncertainty. I am fairly confident that the public places an extremely low probability on the Federal Reserve allowing inflation to average 10 percent over the next decade...  On the other hand, I suspect that market participants place some probability on inflation remaining at around where it is now — a 2 ¼ percent core PCE price index, for example — rather than moderating to 1 ½ percent. In that sense, one might question whether inflation expectations are anchored close enough to the price stability shore. Three-quarters of a percent might seem like a relatively small difference in inflation rates, but sustained over a decade or two, it would amount to a material difference in purchasing power.

Maintaining price stability does not require that the central bank come down hard on every upward twitch in the inflation rate, but disciplined response is required when the inflation rate threatens to rise in a sustained fashion or fall into deflation. Central bankers need to apply their best judgment, and they will not always be correct in those judgments. But if they have a good record and the market retains confidence that the central bank will correct its mistakes, errors in judgment will not do lasting damage. I myself rely heavily on market measures of inflation expectations in forming my judgments and in deciding what policy risks to run—in an uncertain world, it is always the case that policy judgments depend on probabilistic calculations.

Recession, I guess in one sense, is always possible. I think the probability is not very high. I think the probability is a little higher than it might have been two years ago. But the prevailing forecasts certainly do not include recession in the U.S. outlook.

People who are forecasting a recession are decidedly a minority view at this time.

It's true that the empirical evidence suggests that the link is looser, that there's less responsiveness of inflation to employment conditions than there perhaps may have been in past decades.

My own view is that we should take a very eclectic approach in thinking about inflation.

I look at the state of the economy. I try to assess whether demand is exceeding supply in some sense; whether the financial conditions are promoting growth in demand which is greater than the productive capacity of the economy.  But I also look at a wide variety of indicators, including commodity prices, including financial indicators like bond rates and inflation compensation.

I don't think we can rely on any single indicator, particularly one like the natural rate of unemployment concept. It's very difficult to know. Even if there is such a relationship, it's very difficult to assess in real time where that number might be.

And so we really have no alternative but to look at, you know, many indicators -- including {commodity prices} -- to try to assess where inflation's going.

From the Q&A session

It's true that the empirical evidence suggests that the link is looser, that there's less responsiveness of inflation to employment conditions than there perhaps may have been in past decades.

My own view is that we should take a very eclectic approach in thinking about inflation.

From the Q&A session

My own take on what “moderate pace” means is that real GDP is likely to increase by roughly 3 percent over the four quarters of this year—particularly if the housing market is near an inflection point and no longer a significant drag on growth. But I want to emphasize that fluctuations in growth are normal and that no policy action is necessarily indicated if growth comes in somewhat above or below that outlook. When data come in outside the range expected, we need to understand the reasons and the likelihood that the departure will be sustained unless there is an offsetting policy response. Only then does it make sense to consider a policy response.

Regarding the outlook for inflation, I’ve said for quite some time that it might take a while for underlying price pressures to recede. Recent inflation data themselves, and other information relevant to judging the inflation outlook, suggest that the inflation rate is likely to fall into a reasonable range this year. If, however, core inflation seems to be settling at a rate above 2 percent, then such an outcome would be unacceptable to me. I put a very high weight on the Fed’s responsibility to maintain low and stable inflation.

At some point we’ll almost certainly see some surprises in the data. Long experience with economic forecasts indicates that we need to consider as a standard feature of the environment GDP forecast errors in the neighborhood of 1½ percentage points on a four-quarter ahead horizon. Thus, a forecast of 3 percent GDP growth should be expressed as 3 percent plus or minus 1½ percent. From experience, an outcome in this range has a probability of about two-thirds. The other one-third probability is divided equally above and below the range. Thus, the probability of an outcome significantly different from the baseline forecast is not small. The FOMC is prepared to respond when the outcome promises to depart from the baseline in a sustained way.

I will spend some time focusing on an emerging puzzle in the data: why is the labor market apparently going gangbusters, while growth in real GDP has turned in only a middling performance on average in recent quarters?

For example, a significant portion of the personal consumption expenditures (PCE) price index is based on imputations of prices for important categories of household purchases, such as banking services, rather than on direct observations of market prices.  This "nonmarket" component of the index is hard to replicate, tends to move in an erratic manner from month to month, and is subject to considerable revision--factors that reduce the usefulness of the overall index as a short-run indicator of price pressures.

Market-based PCE

[T]he compensation figures in the national accounts are subject to significant revision, as illustrated by the release of new data this week that suggests hourly compensation rose only 4-1/2 percent, not 7 percent, over the past year. Changes such as this make real-time estimates of unit labor costs and labor’s share of total income much less useful in our analyses than studies based on revised data might suggest. Finally, the existing wage data are not well suited for measuring certain concepts important to modeling and policymaking, such as marginal labor costs. For example, hourly compensation in the national accounts includes stock options at their exercise value rather than at their value at the time of issuance.

Brainard’s analysis showed that if policymakers are uncertain about how real activity and inflation will be affected over time by monetary actions, they should be less aggressive in responding to changes in economic conditions than would be the case if they knew the true model of the economy...  [C]entral banks should be cautious about boldly acting on the predictions and policy prescriptions of any one model, especially given that policymakers usually are unsure about the nature and persistence of the shocks hitting the economy.

Central bankers around the world certainly seem receptive to taking a gradualist and cautious approach to policy under most circumstances, as indicated by (among other things) their apparent tendency to smooth interest rates.  The behavior of the Federal Reserve during the second half of the 1990s illustrates this approach to policy...  Staff analysis at the time supported Brainard’s conclusion that the appropriate response to heightened uncertainty about the economy’s true productive potential would be to reduce the importance of the estimated output gap in setting policy.  Whatever the persuasiveness of this analysis, the FOMC did respond in a restrained manner to unusually robust real economic activity--as I believe was appropriate in light of the low and stable inflation that followed.

Most central banks also strive to follow at least the spirit of Bayesian thinking by taking an eclectic approach to forecasting and to policy analysis.  To see this, consider the range of material that the staff supplies to the FOMC.  In the case of the economic projections contained in the briefing document we call the Greenbook, the staff consults a variety of indicators and models and then judgmentally pools this information to produce the baseline outlook.  The staff then supplements this analysis with various alternative scenarios intended to illustrate the primary risks to the outlook.  Although these scenarios are usually constructed using a single model (FRB/US), the simulations actually encompass a wider range of views about the nature of the economy.  For example, the simulations routinely consider alternative characterizations of such key aspects of the economy as the expectations formation process, wealth effects, and the sensitivity of inflation to changes in resource utilization and monetary policy.  Finally, the staff provides the FOMC with estimated confidence intervals for the forecast and produces studies addressing such questions as the optimal design of policy under different types of uncertainty. 

Uncertainty over trend labor force growth will complicate the Fed’s job next year.  While we know that there is no long-run tradeoff between inflation and unemployment, policymakers try to maintain an equilibrium in the labor market at approximately full employment both because full employment is an important goal and because avoiding short-run strains in the labor market helps to maintain price stability.  If actual employment growth slows, we will have to make the judgment as to whether the slowing is consistent with a slowing of trend labor force growth or is a sign of impending recession. If employment growth next year remains only modestly below this year’s average pace of about 150,000 per month, we will have to make the judgment as to whether this growth is outrunning available labor, which would be the case if we accept the low estimate of trend labor force growth, or whether one of the higher estimates of trend labor force growth is being realized. To make this judgment, we will have to collate as many different scraps of information we can find to supplement the standard labor force statistics released every month.

A good central banker knows how costly imperfect data can be for the economy. This is especially true of inflation data. In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent "lower boundary." At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy's ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.

In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth.

It is much easier to agree on a long-run inflation objective than on short-run policy actions consistent with the objective. There is agreement on two conflicting principles. First, it is all too easy to overreact to short-run developments...  Nevertheless, there is also agreement on a second principle: It is all too easy to allow wishful thinking on inflation to delay needed tough policy decisions. The FOMC does its best to make the right choices when, as is often the case, “all too easy to overreact” collides with “all too easy to allow wishful thinking on inflation.”