Loretta Mester

Cleveland Fed President Loretta Mester, asked about her colleague Neel Kashkari's push at the Minneapolis Fed to possibly break up risky banks before they again imperil the economy, said his effort aims to bring more analysis to the lingering issue.

But the 2010 Dodd-Frank reforms have not yet been fully implemented and should be given some "time to work" before "going in a whole new direction," she said.

[F]irms appear to change prices more frequently than predicted by standard macroeconomic models that have been calibrated to match various features of the macroeconomic business cycle. This is a troubling finding in that it suggests a disconnect between the micro data and macro models that are often used to inform monetary policy analysis. Better reconciliation of the models with the empirical facts of the micro data would be a welcome avenue of additional research, and I would expect our models to improve the more we learn.

Yet the labor market’s journey is not yet complete – more progress needs to be made. My outlook is that as the expansion continues, firms will continue to add to their payrolls and the unemployment rate will continue to decline. I expect that by the end of next year, the unemployment rate will fall to around 5½ percent, which is what I view as the “natural rate,” or longer-run rate, of unemployment.

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Putting all of this together, I expect growth over the next six quarters to be somewhat above my estimate of trend growth, which I put at around 2.5 percent. Of course, there is always a good deal of uncertainty around estimates of trend growth, perhaps even more so today in the aftermath of such a deep recession. I am a bit more optimistic than some about longer-run growth because while productivity growth has been running low, I think it is good to remember the experience of the 1990s. Back then, over a period of several years, many forecasters revised down trend growth estimates only to subsequently revise them up significantly in response to strong productivity growth.

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One might ask whether that’s a reasonable inflation forecast given that we haven’t seen much acceleration in wages yet. I believe it is. Cleveland Fed analysis, based on several measures of wages and broader compensation, indicates that it is difficult to find a lead-lag relationship between wages and prices – the strongest correlations are contemporaneous ones, especially since the mid-1980s. We should expect wages to rise with prices, not necessarily lead prices. In my view, it would not be prudent for policymakers to simply wait for wages to accelerate before assessing the implications of the stance of monetary policy for future price inflation. Indeed, policymakers must always be forward looking.

In addition to taking another step to taper asset purchases, in July, the FOMC maintained its forward guidance on interest rates.  This guidance indicated that given our assessment of realized and expected progress toward our dual-mandate objectives, it will likely be appropriate to maintain the current 0-to-¼ percentage point range for the federal funds rate for a considerable period after the asset purchase program ends.  With the end of the program nearing, I believe it is again time for the Committee to reformulate its forward guidance.  The forward guidance the FOMC has offered for the path of the policy interest rate has undergone several changes along the way as we’ve moved from the extraordinary times of financial crisis and deep recession to recovery and expansion.  The guidance has tied the eventual liftoff of the fed funds rate from zero to a calendar date, to a numerical threshold for the unemployment rate, and, more recently, to qualitative information rather than to quantitative measures.

While it might sound best to simply give a date about when liftoff is likely to occur, I believe using a calendar date at this point would be poor communication.  It could mislead the public into thinking that policy is on a pre-set course.  If the public doesn’t understand that policy is dynamic and based on the economic outlook, then a change in the guidance can create its own disruption.  Well-formulated forward guidance also has to recognize that economic conditions can evolve differently than anticipated.  For example, over the past year the improvement in the unemployment rate has been faster than the FOMC anticipated just a year ago.  My preference is for forward guidance to convey that changes in the stance of policy will be calibrated to the economy’s actual progress and anticipated progress toward our dual-mandate goals, and to the speed with which that progress is being achieved.  This latter piece recognizes the importance of policy to be forward looking: A faster pace of progress toward our goals would argue for a faster return to normal, while a more subdued pace would argue for a slower return.

Eleven years ago today, Alan Greenspan, then Chairman of the Federal Reserve, gave an economic outlook speech. The next days headline in The New York Times read as follows: Greenspan Hints at End to Low Rates, while the headline in The Wall Street Journal read: Greenspan Suggests Continued Patience on Rates. That one speech generated such contradictory messages illustrates the challenges monetary policymakers face when communicating with the public.

In extraordinary economic times, forward guidance can be thought of as more than a communications device. It is a tool of monetary policy that has the potential to increase the degree of monetary policy accommodation, especially when interest rates are essentially at their zero lower bound. By reducing uncertainty about the future path of policy, forward guidance helps lower interest rates by reducing the premiums investors demand to compensate them for interest-rate uncertainty.

In addition, in theory, if the central bank indicates that the future path of short-term interest rates will be low for a long time perhaps lower and for longer than would have been consistent with the central banks past behavior this can also put downward pressure on longer-term interest rates, thereby spurring current economic activity. According to the theory, if people believe that the central bank will keep rates very low, they will expect higher economic activity and higher inflation in the future. When households, businesses, and market participants are assured of better economic prospects in the future, they should be more willing to make investments in capital and labor today rather than delaying them, and this will help the current economy.

After several years of nontraditional monetary policy, the transition toward a more normal economy is likely to entail some uncertainty about monetary policy setting. I believe clear policy communications can and should play a key role in reducing that uncertainty. To that end, I favor the Committee being as clear as it can be that monetary policy will be contingent on the state of the economy. I favor putting less focus on a particular calendar date for liftoff. This is why I believe the FOMCs addition to its forward guidance last week was an important step in the right direction. It was a clear statement that if incoming information indicates faster than anticipated progress toward the Committees employment and inflation objectives, then increases in the target range for the fed funds rate are likely to occur sooner than the FOMC currently anticipates. And if progress is disappointing, then increases are likely to be later. I think this is an important message to convey to the public.

During the unusual economic circumstances of the past six years, the FOMC has provided forward guidance to help the public better understand the anticipated future path of interest rates. The formulation of the forward guidance has changed over time, from qualitative guidance, to calendar dates, to economic thresholds, and to a blend of state-contingent and date-based guidance. Lets walk through those changes.

In December 2008, the FOMC began with qualitative guidance indicating that it anticipated that weak economic conditions were likely to warrant exceptionally low levels of the fed funds rate for some time. In March 2009, some time became extended period. In August 2011, the FOMC changed its qualitative forward guidance to a calendar date when it said that it anticipated an exceptionally low fed funds rate at least through mid-2013. That date was later extended to late 2014, and then to mid-2015.

The FOMC changed the formulation of its forward guidance from calendar dates to thresholds in December 2012. The Committee said that it anticipated that the 0-to- percent target range for the fed funds rate would be appropriate at least as long as the unemployment rate remained above 6 percent, inflation between one and two years ahead was projected to be no more than a half percentage point above the Committees 2 percent longer-run goal, and longer-term inflation expectations continued to be well anchored.

A year later, in December 2013, the FOMC blended state-contingent forward guidance with an element of calendar-date forward guidance. First, the FOMC indicated that in determining how long to maintain highly accommodative monetary policy, it would consider information in addition to the unemployment rate and PCE inflation, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The FOMC then translated this into time, saying that based on its assessment of these factors, the 0-to- percent target range for the funds rate would likely be appropriate well past the time that the unemployment rate declines below 6 percent, especially if projected inflation continues to run below the Committees 2 percent longer-run goal.

In March of this year, the thresholds were replaced with guidance that linked the path of policy to the Committees assessment of both realized and expected progress toward its dual-mandate objectives. The guidance continued to provide a time element by indicating that based on the FOMCs assessment, the funds rate target will likely remain 0-to- percent for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

I note that the recent business cycle was not the first time the FOMC has used forward guidance. In August 2003, in the midst of elevated perceived risks of deflation, the Committee indicated that it believed policy accommodation could be maintained for a considerable period. As deflation risks eased and economic conditions changed during that cycle, the forward guidance evolved as well, eventually indicating that the FOMC would be firming policy.

Asked if she's hawkish like Plosser, Mester said she's neither a hawk nor a dove on monetary policy. "I consider myself an owl. Owls are wise." She added that she comes into each Fed policy meeting with an open mind.

But others argued for a more activist approach, with monetary policy being used to try to stem developing imbalances before they caused harm to the real economy. BIS and OECD economist William White characterized these approaches as clean or lean.13 That is, should monetary policy clean up the mess after a bubble bursts, or should it lean against a bubble that appears to be forming?

In general, the macroprudential tools can be classified into two categories: structural tools and cyclical tools. The structural tools aim to build the resiliency of the financial system throughout the business cycle. These tools include the Basel III risk-based capital requirements, minimum liquidity requirements, central clearing for derivatives, and living will resolution plans.

In contrast, the cyclical tools are aimed at mitigating the systemic risk that can build up over the business cycleMacroprudential tools aimed at addressing these emerging risks include the countercyclical capital buffer, the capital conservation buffer, and stress test scenarios. The countercyclical capital buffer allows regulators to increase risk-based capital requirements when credit growth is judged to be excessive and leading to rising systemic risk. The capital conservation buffer ensures that banks raise capital above regulatory minimums in good times so that when they cover losses in bad times, their capital ratio will stay at or above the regulatory minimum. The stress tests can include scenarios that become more severe during strong economic expansions. Other possible cyclical tools, not yet established in the U.S. but used in other countries, include loan-to-value ratio limits and debt-to-income ratio limits that vary over the cycle. In some countries, these macroprudential tools have been targeted at particular sectors like housing credit or household credit. For example, Canada tightened loan-to-value and debt-to income limits on mortgage lending over the 2009 to 2012 period.3 Beginning in 2010, Israel also implemented a package of macroprudential tools to restrict the supply of housing credit.4 Spain introduced dynamic loan-loss provisioning in 2000.5 This method builds up reserves during good economic times according to the historical losses experienced by the asset classes held in the banks portfolio. This buffer is then available to absorb losses in bad times.

One guiding principle we should follow in any regulation is to pay attention to the incentives created by the regulatory system we have put into place. Explicit and implicit rules and the ways they are implemented create incentives. These incentives influence the behavior of all market participants: the financial intermediaries and their investors and customers, and the regulators. A second principle to follow in regulation is to avoid working against market forces. Instead, we should design a system that harnesses market discipline to work with improved regulation. I view Dodd-Franks establishment of the OFR to collect financial firm data, as well the acts permission to compel more public disclosures, as encouraging the transparency needed for market discipline.

I could imagine interest rates going up in the first half of the year, said Mester, a voter on the policy-setting Federal Open Market Committee in 2014, who didnt dissent at any of the meetings she attended after taking the helm at the Cleveland Fed in June.

Across a number of different indicators it looks like the economy is picking up, gaining strength, with headwinds declining and a lower oil prices providing a tailwind, Mester said. My outlook is for a pretty good economy in 2015.

Based on my forecast and the risks I see around that forecast, I believe it will soon be appropriate to begin moving rates up from zero. Because policy must be forward looking, in my view liftoff should occur before our goals are fully met. But even after liftoff, policy will remain very accommodative for some time, promoting attainment of both goals. Indeed, if incoming economic information supports my forecast, I would be comfortable with liftoff in the first half of this year, but as the FOMC has emphasized, policy isnt on a pre-set path. Both liftoff and the path of policy thereafter will be based on incoming information to the extent that it affects the economic outlook and progress toward our goals of maximum employment and price stability.

WSJ: Can you describe the economic setting that will convince you it is time to start raising rates?

MESTER: OK. So Ill just say right off, I want June to be a viable option. Were close to our goals. I do think that monetary policy needs to be forward- looking. I think were going to have to move before we reach our goals. And I think monetary policy is very, very accommodative. And so starting to move interest rates up makes sense.

The exact timing is going to depend on the data. Membership of the committee is going to make a decision about that. But I would be comfortable moving rates up in the first half of the year.
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WSJ: If you want June to be a viable option, then patient has to be altered in some way in the March statement.

MESTER: It is a natural conclusion.

WSJ: Lets talk about how the cycle is likely to play out after liftoff. It sounds like youre saying your inclination is to act and then observe and then consider acting later on.

MESTER: It is not on a preset course.

WSJ: Could there be pauses in the process?

MESTER: Yes, but I cant say now whether there will or wont be pauses. We need to see how the economy reacts and evolves over time. It is hard to sit here today and say that is how were going to behave.

I'm in favor of making sure that June is on the table as a viable option. In my view, and i think the chair explained this quite well in her testimony, taking patient out does not necessarily mean that a rate rise will necessarily come in June. Right? What it means is that June becomes a viable option that we are going to start looking at any meeting, right, we are going to go into the meeting with that being a possibility. Right now, patient is defined as no rate rise for two meetings.
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So I can't tell you that because we are going to be assessing the data as it comes in, in the spring as we get towards the summer, right? We are data dependent in the sense of we look at incoming economic data, see how it effects our outlook, and then set policy based on that. So I can't tell you today what i will or will not support in June because i want to see the data that comes in over that time. I can tell you that my outlook is that the economy actually is picking up momentum. We've had some very strong labor market reports over the last, you know, six months even. Inflation's below our goal, but the report this morning about what was going in the CPI wasn't a surprise, total CPI being low, but core CPI stabilizing. So my forecast is for inflation to go back up to 2 % by the end of next year.

Speaking to reporters, Cleveland Fed President Loretta Mester cited recent labor market improvement, wage gains, stability in the dollar and oil prices, and expectations that inflation will start to rise as reasons for confidence.

"All those things together paint a picture to me that the economy can withstand a small rate increase," said Mester, who has long called for an earlier tightening than many of her colleagues.

"I do think the economy can support a 25-basis-point increase in interest rates," she added. "However I also understand the argument that getting a little more confirming data is reasonable as well."

A Bloomberg News story added that she said that she thought the long-run level of the funds rate was likely to be 3.75%.

While financial market participants are particularly focused on the timing of the first rate increase, when it comes to monetary policy, timing isn’t everything. The FOMC meets eight times a year, and the difference in lifting off from a zero interest rate a meeting or two earlier or later is not significant. More important for macroeconomic performance is the expected path of policy beyond liftoff because expectations about the future path of policy can affect today’s economic decisions. According to the FOMC’s current assessment, even after the first rate increase, monetary policy is expected to remain very accommodative for some time to come, with rates expected to move up only gradually to more normal levels and with the decisions about that path depending on incoming information on the economy’s performance. One benefit of the gradual approach is that it will allow us to recalibrate policy over time as some of the uncertainties surrounding the underlying economy in the post-crisis world, like the potential growth rate, are resolved.

I want to take the time I have between now and the September meeting to evaluate all the economic information that’s come in, including recent volatility in markets and the reasons behind that.  But it hasn’t so far changed my basic outlook that the U.S. economy is solid and it could support an increase in interest rates.

If effective monetary policy means taking away the punch bowl just as the party gets going, then effective financial stability policy might mean taking away the punch bowl before the guests have even arrived because the risks to financial stability build up over time and action likely needs to be taken earlier in order to be effective. Contributing to the need for early action is the challenge of having to coordinate policy action across multiple regulatory bodies. If the need for monetary policy to be forward looking is a difficult concept for the public to grasp, the need for financial stability policy to act well before there are clear signs of instability may be even more difficult to explain. In thinking about the design of the financial stability regime, it might behoove policymakers to consider whether it would be better for central banks to keep their monetary policy and financial stability policy discussions separate so as to avoid jeopardizing the independence of monetary policy.

Based on my current assessment of the outlook and the risks around the outlook, I believe the economy can handle an increase in the fed funds rate and that it is appropriate for monetary policy to take a step back from the emergency measure of zero interest rates. A small increase in interest rates from zero is not tight monetary policy. Indeed, I anticipate that beyond liftoff, economic developments will likely mean it will be appropriate for monetary policy to remain very accommodative for some time to come, supporting continued expansion and providing some insurance against downside risks, with rates expected to move up only gradually to more normal levels and with the decisions about that path dependent on incoming information on the economy’s performance and risks to that performance. Given the outlook, delaying the start of liftoff for too long risks having to move rates up more aggressively later on, but I see benefits of our being able to take the gradual path.

My own assessment is that with the economic progress we’ve made and that I expect to continue, the economy can handle an increase in the fed funds rate. In my view, if economic information continues to come in consistent with the outlook, then there will be a strong case that the conditions for liftoff have been met and it would be prudent for monetary policy to take a step back from the emergency measure of zero interest rates. A small increase in interest rates from zero is not tight monetary policy. And while I would expect some reaction in financial markets to the first move in interest rates in over six years, I wouldn’t expect financial conditions to tighten enough to affect the medium-term outlook.

One benefit of a gradual approach to normalization is that it will allow us to recalibrate policy over time as some of the uncertainties surrounding the longer-term level of interest rates, the economy’s potential growth rate, and the longer-run unemployment rate are resolved. But uncertainty about the longer-run destination is not an argument to delay taking the first step. In fact, in my view, given the economic outlook, starting the process to normalize interest rates will help ensure that we can, indeed, take a gradual approach. Delay risks having to move rates up more steeply in order to promote attainment of our goals over time.

The first question one might ask is, “Why is there a need to improve the U.S. payment system?” There has been a lot of talk of late about the need to improve the infrastructure of the U.S. Mostly this has referred to things like highways, bridges, railroads, aviation, and water treatment, all of which play an important role in fostering economic growth and development. I think we should also consider the U.S. payment system a critical part of the infrastructure of this country. A modern payment system is not a luxury. It is a necessary part of a vibrant economy.

I anticipate that growth over the fourth quarter of last year and through this year will be at an above-trend pace in the 2.5 to 2.75 percent range. My estimate of longer-run growth is 2.25 percent, which is at the upper end of the 1.8 percent to 2.3 percent range among FOMC participants.

In addition to some of the uncertainty around the longer-run steady state of the economy, it bears remembering that our economic forecasting models are, by necessity, simplifications. The economy is dynamic and can be hit by various shocks that might lead to changes in the medium-run outlook for employment and inflation to which policy would want to respond. Indeed, the FOMC’s Summary of Economic Projections, aka the SEP, provides information on average historical errors across a range of forecasts and these show that the confidence bands around forecasts tend to be wide. For example, the 70 percent confidence interval around a forecast of CPI inflation one year out is about plus or minus 1 percentage point. Note that because there is uncertainty around the outlook, there is also uncertainty around the FOMC’s policy path.

When the FOMC says its decisions are “data-dependent,” I view this as shorthand for this more comprehensive process of parsing economic and financial information to determine current economic conditions, and then assessing what that information implies about the economic outlook and the risks around that outlook. Thus, “data dependent” policymaking does not mean that policy will react to every short-run change in the data, but rather that policy will react to changes in the medium-run outlook with respect to the Committee’s monetary policy goals as informed by changes in economic conditions.

“Underlying fundamentals of the U.S. economy remain very sound,” Mester said Monday in an interview on Bloomberg Television. “There’s going to be volatility in the markets, that’s kind of the nature of financial markets.”

It is important to note that “data dependent” policymaking does not mean that policy will react to every short-run change in the data. For example, volatility in financial markets or a change in a short-run data report is not a rationale for making a monetary policy decision. Instead, an assessment has to be made of what the incoming data and financial market developments are telling us about underlying economic conditions and the medium-run outlook. The relevant time horizon for monetary policy is the medium run because it takes time for monetary policy to have an effect throughout the economy.

Until we see further evidence to the contrary, my expectation is that the U.S economy will work through the latest episode of market turbulence and soft patch to regain its footing for moderate growth, even as the energy and manufacturing sectors remain challenged. I continue to expect that growth this year will be sufficient to generate some further improvement in labor markets. I wouldn’t be surprised if the pace of job gains slowed somewhat, but the gains should be strong enough to put additional downward pressure on the unemployment rate.

We don’t know precisely how the economy will evolve; this argues against deciding to end reinvestments after some particular period of time has elapsed. Instead, because some policy accommodation is provided via the balance sheet, it would seem better to base the decision about reinvestments on economic conditions and the outlook, just as we do with the funds rate path. Indeed, the economic conditions and outlook that would support reducing the degree of monetary accommodation by gradually raising the fed funds rate would also tend to support slowly reducing the size of the balance sheet, which would result when reinvestments end. Thus, in my view, the level of the fed funds rate might be used as a guide to when to end reinvestments – in this case, both our fed funds rate path and our balance-sheet policy would be data dependent. I would be comfortable ending reinvestments after we have a few more funds rate increases under our belt, perhaps when the funds rate has reached 1 percent or so. This is my interpretation of “well underway,” but as Chair Yellen indicated in her December press briefing, the FOMC has not given further guidance on this.

I don’t view this “data–dependent” approach to policymaking as something new. Instead, I view it as a step on the journey back from extraordinary to more ordinary monetary policymaking. You will recall that one of the policy tools the FOMC used during the recession and early part of the recovery was explicit forward guidance. That guidance changed over time:
• It began as qualitative guidance offered in December 2008 when the FOMC indicated that weak economic conditions were likely to warrant exceptionally low levels of the fed funds rate for “some time.”
• This changed to calendar–date guidance in August 2011 when the FOMC said that it anticipated an exceptionally low fed funds rate at least through mid–2013.
• Guidance based on economic thresholds was offered in December 2012 when the Committee said that it anticipated that the 0–to–1⁄4 percent target range for the fed funds rate would be appropriate at least as long as the unemployment rate remained above 6 1⁄2 percent, inflation between one and two years ahead was projected to be no more than a half percentage point above the Committee’s 2 percent longer–run goal, and longer–term inflation expectations continued to be well anchored.
• A year later, in December 2013, the FOMC blended state-contingent forward guidance with an element of calendar-date forward guidance, indicating the information it would consider in determining how long to maintain highly accommodative monetary policy as well as an assessment that it would likely be “well past the time that the unemployment rate declines below 6 1⁄2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer–run goal.”
In March 2014, the FOMC abandoned quantitative thresholds and moved toward the type of forward guidance we have today, which links the path of policy to the Committee’s assessment of both realized and expected progress toward its dual–mandate objectives. The guidance continued to provide a time element by indicating it was likely that liftoff would not occur for “a considerable time after the asset purchase program ends.”
After the purchase program ended, using it as a benchmark for guidance became less salient. In January 2015, the FOMC replaced this benchmark and simply said it judged it could be patient in beginning to normalize policy. In March, the FOMC fine–tuned this by stating the two criteria it would use to assess when it would be appropriate to make the first fed funds rate increase. These criteria were further improvement in the labor market and reasonable confidence that inflation would move back to its 2 percent objective over the medium term. Since December’s liftoff, the Committee has continued to indicate that the path of policy will depend on progress toward our goals, and that while the actual path policy takes will depend on the economic outlook as informed by incoming data, the Committee’s current assessment is that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.
This evolution in the FOMC’s forward rate guidance represents a return to more normal times. While explicit forward guidance was used as a policy tool during the recession and early in the recovery, in more normal times, away from the zero lower bound, I believe forward guidance should be viewed more as a communications device.

I continue to monitor developments, but until I see further evidence to the contrary, my current expectation is that the U.S. economy will work through this episode of market turbulence and the soft patch of economic data to regain its footing for moderate growth, even as the energy and manufacturing sectors remain challenged.

When the FOMC says its decisions are “data–dependent,” I view this as shorthand for this more comprehensive process of parsing economic and financial information to evaluate current economic conditions, and then determining what that information implies about the medium–run economic outlook and the risks around that outlook. The medium run is the relevant time horizon for monetary policy because it takes time for monetary policy to have an effect throughout the economy.

I do not think the FOMC is behind the curve, but while there are risks to moving too soon, there are also risks to waiting too long to take the next steps on the normalization path given the lags with which monetary policy affects the economy. We live with uncertainty and one could always make the case that we should wait to act until we gather more information.
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As we've seen over this expansion, things can take unexpected turns, and we want policy to appropriately react to changes in the medium-run outlook. The policy path I foresee as appropriate today is slightly more gradual than the path I foresaw in December, partly because of the slight downward revision to my growth forecast but mainly because I now estimate a lower longer-run equilibrium interest rate. But these are small changes. The important point is that the economy has shown considerable resiliency, and in my view, the outlook and risks around the outlook will likely support gradual reductions in the degree of accommodation this year.

One of the challenges for monetary policymakers is making low-frequency policy in a high-frequency world. We need to extract the signal about where the economy is headed from economic and financial market information that can often be noisy.

My own forecasts tend to have some consistency over time because I try to stay focused on underlying fundamentals and the medium-run outlook.

One needs to remember that there are differences between inflation compensation and inflation expectations. In particular, the inflation compensation measures reflect not only investors’ expectations about inflation but also the amount they are willing to pay in order to protect themselves from inflation risk. In addition, the TIPS market is less liquid than the Treasury market, so there is a liquidity premium in inflation breakeven and compensation rates. We should expect the inflation risk premium and the liquidity premium to vary over time, so one needs to use a model to extract a measure of inflation expectations from inflation compensation. These models can produce very different estimates of the components depending on circumstances. For example, Figure 8 shows the inflation risk premia based on models maintained by the Cleveland Fed staff and the San Francisco Fed staff. You’ll note that even the signs can differ: in the most recent period, the San Francisco Fed model is estimating a negative risk premium while the Cleveland Fed model is estimating a positive risk premium. So the inflation expectations derived from these models can be quite different, as shown in Figure 9. In addition, at times, demand for Treasuries can increase significantly as investors seek safe haven flows for their money. This can make it even harder to infer inflation expectations from changes in inflation compensation. Finally, in the U.S., changes in the inflation compensation measures also seem to be correlated with changes in energy prices, a correlation that suggests they may not be reliable indicators of long-term inflation expectations.

Jon Faust and Jonathan Wright argue that market-based inflation compensation measures are too volatile to be plausible estimates of longer-term inflation expectations, and they show that the data reject the hypothesis that today’s five-year, five-year forward inflation compensation is a rational expectation of inflation in the long-run.

The precision of the forecasts, or lack thereof, needs to be kept in mind when setting monetary policy. We must be forward looking, which means we must rely on models to forecast inflation, but there is no one model that forecasts with much accuracy. The best we can do in this situation is to recognize that there is uncertainty around our forecasts. I am in favor of the FOMC providing some type of error band around its projections. Not only will it help the public understand some of the risks around our forecast, but it will also be a helpful reminder to policymakers that we constantly live with uncertainty. This shouldn’t paralyze us. Instead we should cope with it by looking at the outcomes from multiple models and alternative simulations, using techniques like model averaging, and by continually evaluating the forecasts from the models against incoming data. The FOMC has been expanding the models it routinely examines as a part of the policymaking process — these include the Board of Governors staff’s large-scale FRB/US model and two smaller-scale DSGE models called EDO and SIGMA, as well as various models maintained and utilized at the Federal Reserve Banks. Researchers are now building model archives to aid in the systematic comparison of empirical results and policy implications across a large set of economic models as an aid to policy analysis. One such archive, The Macroeconomic Model Data Base (MMB), headed by Volker Wieland of Goethe University Frankfurt, currently includes 61 models. Given the state of our knowledge, this seems to be a promising approach to ensuring that policy actions are robust across the span of plausible models of economic dynamics and economic circumstances.

So why, then, did I think it appropriate not to raise rates in June? The reason was timing. There was considerable uncertainty about the outcome of the upcoming U.K. referendum on membership in the European Union. The vote was being held a week after the June FOMC meeting. It was clear there was going to be volatility in financial markets surrounding the vote. If the vote favored exit, there was the potential for disruption in markets. Given that I do not think U.S. monetary policy is behind the curve yet, I saw little cost in waiting to take the next step.

In thinking about the economic outlook, I try to stay focused on underlying fundamentals because they determine the outlook for the economy over the medium run, the time horizon over which monetary policy can affect the economy. In my view, the underlying fundamentals supporting the U.S. economic expansion remain sound. These include accommodative monetary policy, household balance sheets that have improved greatly since the recession, continued progress in the labor market, a more resilient banking system, and low oil prices. There are risks around all forecasts, but my modal forecast has been that over the next two years the U.S. economy will continue to expand at a pace slightly above its longer-run trend, which I estimate to be about 2 percent; that the unemployment rate will remain slightly under its longer-run level, which I estimate to be about 5 percent; and that inflation will continue to gradually return to the Federal Reserve's 2 percent target.

In June, the FOMC also indicated that economic developments will likely warrant only gradual increases in the fed funds rate. Of course, the timing of those rate increases and the overall slope of that gradual path will depend on how the economy, the economic outlook, and the risks evolve.

Indeed, in the June projections, the median fed funds rate path of appropriate policy was somewhat shallower than in the last set of projections in March — partly reflecting somewhat slower growth projected for this year, and partly reflecting a lower estimate of the fed funds rate over the longer run.