Using new tools to manage policy as we have in the last two years does create particular challenges in communicating our actions, intentions, and reasoning to the public. The statement has been an essential element in addressing these challenges. For example, the announcement of a target for the federal funds rate combined with a phrase such as "extended period" gives the market a sense of current policy and the policy expectations for the future. Over time, market participants have learned how to translate that sort of statement into expectations for market and economic conditions. When we began large-scale purchases of mortgage-backed securities and agency debt, however, that decision was much more difficult to interpret. So we communicated that we expected to purchase x amount of securities over y amount of time. In subsequent statements, we reiterated that intention, added to some totals, subtracted from others, added purchases of Treasury securities, and ultimately stated our intentions to stop purchasing the securities.

In making our assessments about next steps, we need to be a bit humble about our capacity to forecast how market participants would respond to our actions. We do not control their behavior nor have much historical experience that we can draw on to easily assess how they are likely to behave. Even viewpoints that turned out to be incorrect could persist for a long time and generate adverse consequences. It is not enough for us to be right in theory. We also have to be convincing in practice and in explaining why concerns we think are misplaced are indeed unwarranted.

...[A] small precautionary action to avoid any risk associated with inadvertent tightening was prudent, in my view, in the midst of disappointing economic indicators.

That is how I interpret the decision announced following the August meeting—a small tactical change designed to preserve the level of liquidity provided to the system. I supported the committee's decision, but I do not view it as a fundamental change of outlook or strategy. I do not believe this change necessarily heralds the beginning of a period of further expansion of the Fed's balance sheet. Nor do I think the decision precludes a return to a policy of allowing the balance sheet to shrink on its own.

I think the decision has been over-interpreted in some quarters. These interpretations, along with alarmist commentary about deflation and a double-dip recession, are feeding an exaggerated sense of foreboding.

Before this week’s FOMC meeting, The Wall Street Journal wrote that the Fed would add more stimulus into the economy—including the purchase of long-term treasuries. It turns out that reporter was remarkably prescient.

[F]acts, not force, should be the predominant policy response. Prevailing wisdom has it that policymakers must overreact when markets do. In my view, this is an uncertain proposition. If a problem were unique or isolated, game theory suggests that overwhelming force might serve policymakers' interests. But, these problems are not isolated. And it is no game. Markets will continue to clamor for more explicit government commitments. Better to feed the proverbial beast with more facts than force. The Federal Reserve-led stress tests are but one example where the balance was reasonably struck.

My view was that we should change the language. I didn't object on the fact that interest rates were low at this time, but I think policymakers need to have the broadest options possible and the language that we use, that is very low for an extended period, was appropriate during the height of the crisis to assure that we were not going to make any changes, but now the economy is beginning to recover. It has been in recovery now for two quarters. We have to be thinking a little bit longer ahead and that's really what my admonition was.

In response to a question about his dissenting vote against the "extended period" clause in the January FOMC statement.

[W]e said we would keep short term rates low, exceptionally low for an extended period.  So until we change that, that’s where we are. Short term rates are going to stay low for a considerable period of time to come... among my very informal set of people that I asked that question they said that “extended” in their minds means at least six months... So what I want to stress is extended means at least six months. It could be a year from now… two years from now. It’s going depend on how the economy develops.

“Our ‘extended period’ language indicates that’s some substantial number of meetings,” Evans told reporters today after a speech in Coralville, Iowa. “I have said before that’s at least three or four meetings away.” The Federal Open Market Committee’s fourth meeting of 2010 is scheduled for June 22-23.

What does "extended period" mean? I don't want to put a date on it. To me, it means the policy rate will be kept low until recovery has shown momentum that is based on private business and consumer demand, job growth is established or at least imminent, and the downside risks appear to be safely navigable.

In standard theoretical model environments, long-run inflation expectations are perfectly anchored. In reality, however, the anchoring of inflation expectations has been a hard-won achievement of monetary policy over the past few decades, and we should not take this stability for granted. Models are by their nature only a stylized representation of reality, and a policy of achieving "temporarily" higher inflation over the medium term would run the risk of altering inflation expectations beyond the horizon that is desirable. Were that to happen, the costs of bringing expectations back to their current anchored state might be quite high.

Financial markets have not fully understood that the U.S. Federal Reserve's pledge to keep interest rates exceptionally low for an extended period means they will stay low beyond when officials normally would raise them, a top Fed official said on Friday.

"I don't think markets have really digested what that means," St Louis Fed President James Bullard said in an interview.

A certain degree of ambiguity...I would hope, could help temper moral hazard concerns.

As reported by Reuters.

Later today, with the release of the minutes of the most recent FOMC meeting, we will be making an additional significant enhancement in Federal Reserve communications: To supplement the current economic projections by governors and Reserve Bank presidents for the next three years, we will also publish their projections of the longer-term values (at a horizon of, for example, five to six years) of output growth, unemployment, and inflation, under the assumptions of appropriate monetary policy and the absence of new shocks to the economy. These longer-term projections will inform the public of the Committee participants' estimates of the rate of growth of output and the unemployment rate that appear to be sustainable in the long run in the United States, taking into account important influences such as the trend growth rates of productivity and the labor force, improvements in worker education and skills, the efficiency of the labor market at matching workers and jobs, government policies affecting technological development or the labor market, and other factors. The longer-term projections of inflation may be interpreted, in turn, as the rate of inflation that FOMC participants see as most consistent with the dual mandate given to it by the Congress--that is, the rate of inflation that promotes maximum sustainable employment while also delivering reasonable price stability. This further extension of the quarterly projections should provide the public a clearer picture of FOMC participants' policy strategy for promoting maximum employment and price stability over time. Also, increased clarity about the FOMC's views regarding longer-term inflation should help to better stabilize the public's inflation expectations, thus contributing to keeping actual inflation from rising too high or falling too low.

An extensive body of literature suggests that communications can play a helpful role in addressing the zero-bound constraint. In particular, by offering guidance about the likely course of future short-term interest rates, conditional on the Committee’s economic forecast, the Fed may be able to influence longer-term rates and asset prices.  The Fed employed such an approach between 2003 and 2005, and has taken an important step along the same path in its December announcement by stating that “exceptionally low levels of the federal funds rate” are likely to be warranted “for some time” due to “weak economic conditions.”

Communication also can be important in the Fed’s efforts to anchor long-term inflation expectations. As I mentioned at the outset, the odds are high that over the next few years, inflation will decline below desirable levels.  It is especially important in such circumstances for the Fed to emphasize its commitment to returning inflation over time to the higher levels that are most appropriate to the attainment of its longer-term objectives. A decline in inflationary expectations when economic conditions are weak is pernicious, especially so when the federal funds rate has reached the zero bound, because any downdrift in inflation expectations leads to an updrift in real interest rates and a tightening of financial conditions.

One important tool is policy communication.  Even if the overnight rate is close to zero, the Committee should be able to influence longer-term interest rates by informing the public's expectations about the future course of monetary policy.  To illustrate, in its statement after its December meeting, the Committee expressed the view that economic conditions are likely to warrant an unusually low federal funds rate for some time.²  To the extent that such statements cause the public to lengthen the horizon over which they expect short-term rates to be held at very low levels, they will exert downward pressure on longer-term rates, stimulating aggregate demand.  It is important, however, that statements of this sort be expressed in conditional fashion--that is, that they link policy expectations to the evolving economic outlook.  If the public were to perceive a statement about future policy to be unconditional, then long-term rates might fail to respond in the desired fashion should the economic outlook change materially.