My topic is how the Fed adjusts policy when the economy departs from the central tendency outlook. Of course, forecasters commonly have somewhat different views but each forecaster’s central tendency, or baseline, forecast provides his or her best guess as to how the economy will evolve. However, forecasters also need to be able to say something about probabilities of other outcomes. The probability distribution of possible outcomes is substantially affected by policy responses to deviations from the baseline outlook if and when those deviations occur. And, although I say “if and when,” everyone in the forecasting business knows that our knowledge of forecast errors requires that we put much more weight on the “when” than the “if.”

An often overlooked implication is that, all else equal, an increase in the growth rate of productivity will tend to put upward pressure on real interest rates.  But in fact we have not seen the predicted rise in real rates.  Of course, we do not live in the world of simple economic models so all other things are not equal.  In particular, I believe one reason is that sound economic policies have created a more stable economic environment, and with that has come low and stable inflation and an ongoing desire by foreigners to invest in the United States to reap higher returns associated with higher productivity growth than may be available in their economies.        

It is easiest to describe the rational expectations equilibrium in a context of certainty. But, of course, all the really interesting questions arise in a context of uncertainty.

To summarize — I see growth for the next year or so in the high 2’s, approximately full employment, and core inflation subsiding.  Not a bad picture, particularly given the challenges I mentioned a moment ago.

The next obvious question concerns risks — where are they and how likely are they to materialize?  In my view, risks have grown over the summer on both sides of this forecast.  Growth could be slower or inflation could be higher and more persistent -- or both.  I take both of these risks seriously.

The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still "in the pipeline." ...

...[P]olicy must be flexible and ready to adjust to changes in economic projections. In particular, as the Committee noted in the statement issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by our analysis of the incoming information.

Experience with current account adjustments by industrialized economies--for example, by the United States in the 1980s--suggests that the transition to a more sustainable configuration is not likely to be disruptive. But we cannot be sure, particularly because the U.S. experience is unique given the dollar’s role as a reserve currency and Americans’ relatively favorable returns on assets held abroad. The world economy is in uncharted territory with regard to the size of the imbalances.

I think that the market is reading the current numbers in a very sensible way. And what I think we are - need to pay attention to are not little nuances around the current numbers but rather the bigger things that may come along and surprise us. When everything is coming in on-track, no surprises, there really shouldn't be very much to talk about. We need to be thinking ahead to surprises.

HAYS: As a matter of fact, that up-tick says - predicts that the market's saying that the Funds rate is going to five-and-a- quarter percent. Does the market have it right?

POOLE:   We won't know whether that's right.  I think it's a perfectly reasonable understanding given the information that is now available.   But what I want to emphasize is that the information changes all the time. And that we need to understand the surprises that are coming down the pike and the sensible way to react to those surprises. Now I can't forecast the surprises any better than anybody else can.

Given this reality, policymakers are well advised to follow two principles familiar to navigators throughout the ages:  First, determine your position frequently. Second, use as many guides or landmarks as are available In the context of monetary policy, these principles suggest that policymakers should monitor bond yields carefully in judging the current state of the economy--but only in tandem with the signals from other important financial variables; direct readings on spending, production, and prices; and a goodly helping of qualitative information. Ultimately, a robust approach to policymaking requires the use of multiple sources of information and multiple methods of analysis, combined with frequent reality checks. By not tying policy to a small set of forecast indicators, we may sacrifice some degree of simplicity, but we are less likely to be misled when a favored variable behaves in an unusual manner.

[I]n any area of central bank communication, in some ways the critical thing for us to do is not to leave you with less uncertainty than we have about what we know about what's happening.  And we try to be very careful not to convey more confidence than we could reasonably have about what's happening to the forecast, and what that means for - for monetary policy.

From audience Q&A session

This is not a time for complacency. Financial-market innovations, some of which have not yet been rigorously stress tested, along with a macroeconomic environment that, while most likely stable and constructive, contains significant uncertainty, suggest that vigilance and adaptation by both market participants and regulators will be necessary to improve the odds of sustaining this era of damped economic cycles and supporting the orderly evolution of financial markets.

Oil futures markets are indicating that higher energy prices may well be with us for quite a while. And how businesses and individuals react to this energy price outlook—both short and long term—is a key economic uncertainty.

The fact is that the standard error for the one-month change in payroll numbers is nearly 70,000, and making too much of any one monthly number is ill-advised...it is important to not overemphasize short-term deviations while ignoring long term trends.

The fact that there is uncertainty surrounding the state of the economy and new economic information becomes available on a nearly continuous basis supports the notion that it makes sense for policymakers to move in a slow and cautious manner.

The economic world in which we function is best described by a structure whose parameters are continuously changing. The channels of monetary policy, consequently, are changing in tandem. An ongoing challenge for the Federal Reserve--indeed, for any central bank--is to operate in a way that does not depend on a fixed economic structure based on historically average coefficients...

Moreover, we recognize that the simple linear functions underlying most of our econometric structures may not hold outside the range in which adequate economic observations exist. For example, it is difficult to have much confidence in the ability of models fit to the data of the moderate inflations of the postwar period to accurately predict what the behavior of the economy would be in an environment of aggregate price deflation.