Sandra Pianalto

The neutral range for the federal funds rate during the next several quarters and beyond will depend on how economic conditions unfold, but our experience suggests that during extended periods of reasonably sound and sustained economic performance, the neutral federal funds rate will almost certainly be above today’s level of 1.5 percent.  In fact, historical experience suggests that when our economy is operating soundly and when resources are at high levels of capacity utilization, the neutral range is likely to be 3 to 5 percent. Where does this estimate come from? Without going into the exact formula, the most important components in the equation are the rates of productivity growth and expected inflation. As either one of these factors moves up or down, so too will the neutral federal funds rate.

The momentum in the inflationary process has clearly shifted away from disinflation. And, unfortunately, it is not always possible to distinguish short-term movements in the price indexes from the emergence of an inflationary trend until after the fact...Monetary policy makers have to anticipate the potential for inflation to creep up over time if the policy rate does not move up as well—in other words, if policy unintentionally becomes accommodative.

If foreign sources for financing our consumption and investment shrink, then it would be logical to see greater upward pressures on interest rates in the financial markets, as long as overall economic growth remains solid.

The economic impact of any given deficit almost certainly depends on the spending and tax policies that give rise to the budget shortfall...But it would not be shocking to find that there might be some interest-rate pressure from this source, at least in the short run.

We still see signs that the current level of the real federal funds rate target remains below the level that is most likely needed to keep inflation stable and economic output at its potential.

Recognizing how difficult it is to know when policy is truly neutral, I think it is prudent to move the federal funds rate up to a position that gives me more confidence that monetary policy is no longer accommodative. I would prefer this strategy to finding out the hard way—for example, through a deterioration in inflation expectations or in the inflation picture itself—that we had maintained an overly accommodative stance for too long.

Over time, central bankers have learned some important lessons—namely, that there is a lot of inertia in the inflation process, and that we cannot underestimate the possibility of inflation creeping in. And once an inflationary psychology takes hold, it can be difficult and costly to reverse.

Some nations, along with the European Central Bank, have chosen to set explicit numerical inflation-rate objectives for their central banks. Others, like the United States, have been fairly successful without them.

Deficits can indeed be a problem...Real interest rates could rise as government deficits crowd out business and consumer investment. But...there is no need for deficits to be inflationary. The prospect of inflation arises only if the central bank tries to resist the rise in real interest rates, thereby keeping its policy rates too low and inadvertently easing monetary policy.

In the long run, a central bank supplying more money cannot create more energy resources, but a credible monetary policy will help smooth economic adjustments that higher energy prices might require.

Business people I talk to continue to say they continue to see some rising input costs.  But they are not able to fully translate these rising costs into their own prices.

It is difficult to explain what has happened to [long-term interest] rates.  I think the credibility of monetary policy is an aspect.

The conundrum was the Chairman's conundrum.

I think that being more explicit about our inflation objective could help us to be successful in maintaining price stability, but my expectations are modest. I do not regard an explicit numerical price objective as a panacea. We might gain some additional credibility with the public by simply being clearer than we are today and, at the same time, greater clarity might impose some extra self-discipline when we really need it.

In my view, this ["measured pace"] language has provided useful guidance in the limited time we have used it, but there is a risk that at some point the Committee will take an action that the public regards as contrary to what is implied by the language. To me, this risk suggests that the Committee should provide this type of guidance only when it is highly confident in the course of its near-term policy actions and when it perceives the cost of being misunderstood as exceptionally great.

The step I have in mind would have the FOMC provide an additional three- to five-year projection for inflation. This would be based on the participants' working definitions of price stability and policies that support them. The ranges and central tendencies of these extended projections would be made public, perhaps in an expanded discussion in the Monetary Policy Report. I would not be surprised to discover that the extended three- to five-year inflation projections of the individual FOMC participants converge to a fairly narrow range. This convergence could provide the foundation for a more formal inflation objective at some point in the future.

Generally we've seen a pick-up in some inflation measures, but expectations have stayed anchored.

A central bank cannot always offset the effects of government deficits on economic growth and stability. But the more credible the central bank's commitment to price stability, the less likely it is that an inflation premium will be built into market interest rates, and the less likely it is that rising inflation expectations will distort economic decisions.

Today, I find many people blaming globalization for some of the changes we are facing as a nation. I am more inclined to see these changes as a natural by-product of our own economic development, and only accelerated by globalization...If we want to improve our living standards, then we have to accept the hard truth that some businesses and occupations will become obsolete along the way and others will spring up to take their place...Our economic future will depend on our ability to continue to let go of the past.

I think it is time to stop focusing on short-run job losses, as difficult as they are. We must start focusing more on the long-run adaptability of our businesses and our capacity to grow new ones. The jobs will follow...We need to shift the focus from preserving the past to creating the future.

We still see a few unusual trends in this expansion: namely, weak employment growth, strong productivity growth, and higher energy prices. But the underlying fundamentals are strong nationwide - low interest rates, low inflation, robust productivity growth, and strong business balance sheets.

In a global economy that grows more competitive every day, the words "education" and "opportunity" are becoming increasingly synonymous. For the individual, a high-quality education is a decisive stepping-stone to increased earning power. For the region, creating a civic culture that supports education is the most promising pathway to creating a base for innovation.

Let me spend just a moment explaining how I look at inflation. As a policymaker, I pay attention to the "core" measures of consumer price inflation as well as the overall "headline" measure of consumer price inflation, because the headline number can be somewhat misleading.

In the simplest measure of core inflation, changes in food and energy prices are eliminated from the calculation. More complicated core inflation measures eliminate prices that are growing both very quickly and very slowly. In any case, the idea is to strip away the "noise" of volatile price changes, so that we can see the underlying inflation trend more clearly.

Of course, the FOMC's mandate is to control overall inflation: the average of all prices, including food and energy, as well as all the other things you buy. But we have found that measures of core inflation tend to be better predictors of future inflation than the headline rate, giving us a better picture of the true inflation trend.

It would not surprise me too much to look back and see that some of the growth we thought would occur in the final three months of last year was actually spread across the third quarter of 2005 - when GDP growth was stronger than expected - and the first quarter or two of this year.

If [the recent slow employment growth] is defined as a demand condition, perhaps poor job prospects have discouraged people from even attempting to find work. Will another year like 2005 reverse the recent trend? And does that mean that monetary policy should be accommodative until the economy is once again generating substantially more than 2 million new jobs per year? Alternatively, if the lower labor-force participation rate is defined as a supply condition, then it may be driven by younger workers' deferring entry into the labor force - perhaps to obtain more schooling and skills. If that is the correct explanation, then potential employment will be calculated much differently from the number we saw in the 1990s. In that case, attempting to spur more rapid job growth with an accommodative monetary policy is exactly the wrong thing to do. It will not accomplish the goal of maximum sustainable growth in the long run, and it may threaten our goal of price stability.

The sectors of the economy that will support our economic growth this year are expected to be somewhat different from those that prevailed in the past few years. The housing market, after several years of strong expansion, is already showing signs of cooling off this year. Consumer sentiment has been deteriorating, according to the latest survey responses, and recent data show signs that consumer spending is softening from its strong first-quarter performance.

Consumers have sustained their spending during the past several years, in part, by cashing out some of their home-equity dollars. This extra source of financing is likely to slow down in a softening housing market. Fortunately, though, I expect to see enough employment and income growth coming out of the labor market to keep consumer spending advancing at a moderate rate.

On the business side, I look for capital spending to continue to expand at a decent pace again this year. Stronger economic growth abroad will also boost American exports. These two sectors - business spending and exports - are likely to mitigate the effects of a slowdown in the consumer and housing sectors.

As the year progresses, I anticipate that the pace of economic expansion will slow from its rapid rate of growth in the first quarter. Nevertheless, I believe that we are on track to achieve our objective of sustainable economic growth.

The core CPI has increased at an annualized rate of more than 3 percent during the past three months. This inflation picture, if sustained, exceeds my comfort level.
Fortunately, the public is, for the most part, looking at this disappointing inflation news as a transitory development. Measures of long-term inflation expectations have been mixed lately, but, on the whole, I regard them as remaining contained. The FOMC's challenge is to make sure that they stay contained.

I expect a flattening-out of energy prices, a cooling housing market, continued strong productivity growth, and a moderation in the overall pace of economic activity.

Americans with weaker job-market skills have not benefited as much from the growing U.S. economy as have other Americans with higher-level skills. Economists call this "skill-biased technical change." People who lack the skills needed to keep up with changes in technology cannot take full advantage of the benefits of the growing sectors of the economy. If lower-skilled Americans fall further behind, the result will be increased income inequality and, ultimately, greater poverty.

When you get right down to it, we really know very little about how people form their inflation expectations.  To what extent are expectations based on past inflation experience versus looking into the future? Do people scour all of the available data to predict inflation, or do they just consider the information most readily available to them? And, perhaps most important, how do people act on the inflation expectations that we measure through the household surveys?

There is much at stake in the answers to these questions. We might discover important differences between household survey information and financial market data. We may also find an answer to one of the great questions - and obstacles - in the monetary policy process. Namely, are inflation expectations responsible for the long time it takes for monetary policy actions to show up in the inflation data?

Understanding what lies behind our measures of inflation expectations could greatly enhance the design and conduct of monetary policy. For example, it could help us understand what types of institutional arrangements and communication policies help the central bank retain credibility for meeting its price stability objective, even when large and persistent relative price changes ripple through the inflation data.

To that end, unlocking some of the mysteries about inflation expectations may help central banks decide whether, and how, to incorporate a numerical inflation objective into the monetary policy process.  Some central banks have used these numerical objectives as a tool to help anchor inflation expectations. Economists refer to a numerical inflation objective as a "commitment device," that is, a means for holding a central bank's feet to the fire. That may be so. But whether or not there is an explicit numerical objective, anchoring inflation expectations requires a central bank to keep inflation low and stable, to reinforce its commitment to price stability, and to clearly communicate its policies in pursuit of that commitment

Appreciating this distinction helps one better understand ideas like "core" inflation, which are useful metrics for the central bank, and perhaps only the central bank, to monitor. These core inflation measures, most commonly constructed as an aggregate price statistic less food and energy prices, attempt to strip away the most volatile of the relative price movements that may temporarily cause the aggregate price measure to fluctuate in a way that is not symptomatic of a persistent change in the purchasing power of money.

The problem with financial market indicators is that asset prices respond to any number of risks, not just inflation.   In a world that is always confronting and evaluating risks, disentangling the inflation risk from all the other risks is a very imperfect science. Nevertheless, financial market indicators are proving to be a useful yardstick for monitoring inflation expectations...

You might think that a better way to gauge inflation expectations would be to simply ask people their views on inflation. In fact, there is a survey that does just that. Once a month, the University of Michigan interviews about 500 households around the nation, asking people how much they think prices will rise in the next 12 months and over the next 5 to 10 years. Here, too, there are some problems with interpreting the raw data. For one thing, households' beliefs about future inflation are typically much higher than the actual inflation rate.

Also, investigations into the survey data have revealed some fascinating patterns. For example, people are likely to report their inflation predictions in terms of whole numbers, and particular whole numbers at that. It turns out that people are far more likely to report that they expect 0, 3, or 5 percent inflation than 1, 2, or 4 percent.

Back in 1968, Milton Friedman warned economists and policymakers not to try to stimulate economic growth at the cost of "just a little more" inflation.  He predicted that people would come to anticipate that little bit of extra inflation, and then would change their behavior in various ways. The end result would be slower economic growth and ever-higher inflation. In effect, Friedman was warning policymakers not to treat inflation as a static concept, but to appreciate the interdependence between inflation and inflation expectations.

Unfortunately, the economic events of the 1970s bear out Friedman's warning. Households and businesses did adjust their behavior to minimize the costs they faced from rising inflation. And once inflation expectations became unglued, we watched with dismay as the costs arising from inflation expectations took a huge toll on our resources. The economy spiraled into "stagflation" - an environment of worsening economic performance and higher inflation.

How can we control the average price level over time? To paraphrase a famous economist, Irving Fisher, the average price level doesn't rise because of the goods; it rises because of the money.  Simply put, if growth in money exceeds its demand, its purchasing power will depreciate. This is inflation. It affects all prices and wages, and ultimately it has only one origin, the central bank. This is because the central bank is solely responsible for managing the nation's money supply.

You might think of the statistical data that we gather on the economy as being like the readout on your car's dashboard: All of the information is meant to tell you what is happening to your car, but it typically does not tell you why it is happening. When the oil light on your car's dashboard comes on, you know that the oil level is probably low, but you don't know why. Maybe there's a leak, or maybe your mechanic left the cap off the reservoir. To find out, you have to look under the hood.

Meeting with people is my way of looking under the economy's hood. The conversations enable me to understand the why behind the what. They help me judge which of the various explanations being offered for the condition of the national economy is most reasonable.

[T]he judgments associated with monetary policy are not always as obvious as they might appear. Economic conditions can be unpredictable, and we are under no illusion that we are perfect forecasters. To paraphrase former Federal Reserve Chairman Alan Greenspan, we are essentially risk managers. We need to make policy choices that stand the best chance of moving us toward our objectives, given our imperfect understanding of the changing environment around us.

In fact, setting the federal funds rate target is a little like throwing a forward pass in a football game.  Any good quarterback knows that you cannot just throw the ball to where the receiver is when you see him.  You have to throw the ball to where you thinkhe will be by the time the ball gets downfield.  So it is with setting the federal funds rate.  It is not just where the economy is positioned today that matters, but also where we think it is headed.  That's a little free advice for Ben Roethlisberger. 

Fortunately, despite the housing risks I have described, other sectors of the economy still look pretty good.  For the most part, consumers are still buying things.  Businesses are still investing in new plants and office buildings.  And foreign economic activity also remains strong, which provides an additional source of demand for our goods and services.  Certainly the tone in labor markets has been very positive lately.  Continued hiring suggests a high level of business confidence about economic growth next year.

            Think of it this way.  We seem to have two economies at work - the housing economy, which is experiencing a very large adjustment, and the "everything else" economy, which is performing fairly well. 

The inflation outlook is a slightly different story.  I do not believe that inflation will accelerate further.  In fact, I expect some slowing in the rate of inflation as recent energy price changes and the effects of monetary policy actions work through the economy.  But some risk remains that inflation will not recede into a range consistent with the FOMC's price stability objective.  In that event, it is possible that some additional monetary policy restraint would be required.

Economists at our Bank have been studying this aspect of the economy for several years now. Recently, they have concluded that differences in state income levels over the past 75 years can be explained mostly by two factors: innovation and education. In simple terms, those states that enhance their knowledge base are the ones that are likely to prosper in the future.

... I see the economy growing at a more moderate pace over the next few years than we saw in the past couple of years. But there are risks to this outlook. The first risk is that the weakness in the housing sector spills over to other sectors of the economy, depressing overall growth. The second risk is that inflation remains stubbornly high...

The most recent price statistics have been encouraging, but not convincing...

...[T]here is still a risk that the underlying inflation trend will not continue to improve; in which case, the FOMC will need to respond with the appropriate policy actions.

The latest data show that prices of new and existing homes are no longer falling, and inventories of unsold homes have dropped a bit. However, a sharp decline in building permits still suggests that investment in new housing will remain weak at least through the first half of this year, as the adjustment process continues. This current housing slump is temporarily pushing overall economic growth below its longer-term growth path.

However, the price statistics have been unusually difficult to interpret lately. We are seeing a lot of extremes within the Consumer Price Index. Prices of some items in the index are rising at rates of 10 percent or more, while prices of other items are falling by more than 10 percent. Very few prices are increasing at the relatively low rates consistent with price stability. With so much price dispersion, it is difficult to know where the inflation trend will settle out.

Monetary policy decisions are made without the direct input or the immediate approval of the other branches of government. This helps keep monetary policy independent of political pressures and influence. Nevertheless, we are independent within the government - not of the government. Ultimately, we are accountable to Congress for achieving two objectives: price stability and maximum sustainable economic growth.

Some observers think that the worst of the national housing contraction is behind us. That view may be premature, but the recent data are encouraging. Home sales no longer seem to be falling, and inventories of unsold homes have dropped a bit. And even though new homes under construction fell sharply last year following several years of strong growth, most economists expect further declines to become less steep.

The national inflation picture has been clouded in the past few years by large swings in energy, commodity, and housing prices. As these markets normalize, and as we gain a clearer picture of the underlying inflation trend, we may see that some inflation risks remain. In that case, some additional policy firming may be needed - depending, of course, on the outlook for both inflation and economic growth.

I don't mean to imply that monetary policymakers ignore short-term economic fluctuations. We don't. Indeed, we calibrate our policy actions to have the best possible overall effect on short-term and long-term economic conditions. But supply and demand factors in the economy must ultimately adjust on their own. Our role is to provide a stable environment that enables these short-term imbalances to work themselves out in the least disruptive manner.

Inflation targeting is a communication tool. This issue is under review in the committee.  I personally believe that setting a numerical inflation objective does help communication both within the committee and externally.

During Q&A discussion, as reported by Bloomberg News

Among these benefits is our ability to borrow from the rest of the world at a low interest rate. Between 1980 and 2005, for example, the income paid to foreigners who owned U.S. assets was 4.9 percent on average. However, the income paid to Americans who owned foreign assets was 6.3 percent. In other words, the United States effectively borrowed at a discount of 1½ percent.

Some people have argued that this spread partly reflects the fact that the United States tends to borrow from the rest of the world in the form of safe, relatively short-term government debt, and much of U.S. lending to the rest of the world is in the form of foreign direct investment or riskier, long-term debt. While there is truth to this claim, I think that most people would agree that at least part of the difference in returns on investment reflects a willingness by foreigners to pay a liquidity premium to hold assets denominated in U.S. dollars.

I truly believe that a nation or region benefits when its currency becomes an international reserve currency.   To sustain that status, the monetary authority must show that it will remain committed to protecting the purchasing power of its currency.  Global competition for international reserve currencies gives central banks an added incentive to pursue that goal. 

The Federal Reserve was largely created to act as a lender of last resort, and central banks have often provided liquidity in times of large-scale financial stress. I think this is the appropriate response to financial market turmoil, but in any given case there are still questions of how much to intervene, and for how long. How those questions are answered can have longer-term consequences for inflation expectations.

I can assure you that every word and every nuance in our communications are carefully considered. It is essential that the public understand our interpretation of the economic situation and that they support our policies. In a very real sense, our communications have become a part of the policy process, because we understand that influencing inflation expectations is an important dimension of monetary policy.

The reality of rising oil and commodity prices is evident, and my Federal Reserve colleagues and I have been clear about our belief that the impact of these influences will dissipate over time. But until our beliefs are validated by the data, there is a risk that the public's trust could erode and inflation expectations could move higher.

For example, let's recall what happened with U.S. monetary policy beginning in the latter half of 1998. At this time, we were well into the turmoil that began in Southeast Asian economies the summer before. In September 1998, the Federal Open Market Committee informally convened via telephone for an unusual pre-FOMC meeting discussion regarding the unsettled nature of financial markets. At the formal FOMC meeting soon afterward, the Committee cut the federal funds rate target, followed by two additional cuts in October and November. In each case, the record makes clear that the Committee's decisions were greatly influenced by the unusual strains in financial markets.

Since 2005, the three- to five-year moving average of U.S. inflation has hovered around 3 percent. This is above where I would like to see the trend settle in the longer run.  [Note:  These figures are measured by the Consumer Price Index.]

Some central banks hold regular press conferences. And, of course, some have established explicit numerical objectives - or inflation targets - and publish economic projections that clearly show what they are aiming at and how they expect to get there. Our different approaches are, in part, a result of our different histories and governance structures.  But also, I think, central banks are still developing "best practices" for securing inflation expectations in the face of unknown future risks.

However, differences in tactics should not be confused with differences in intent. I believe that my colleagues - and indeed, most central bankers today - are working to achieve the same end. We are all trying to create an environment in which inflation is so low and stable that it does not influence the decisions that households and businesses would otherwise make.

Unless the deficit problem is addressed through explicit fiscal policies or changes in national saving rates, creditors might reasonably conclude that debtor governments will resort to inflationary policies. Ultimately, however, central banks cannot control either fiscal policy adjustments or private consumption decisions. If fiscal dynamics don't improve, central bankers could once again face the difficult challenge of maintaining price stability in a world where expectations are moving in the wrong direction.

Recently in the United States, the Federal Reserve's Federal Open Market Committee has described our core rate of inflation as being uncomfortably high and has stressed the importance of further moderation in inflation. 

At the Federal Reserve, the Board of Governors is carefully considering how it might further use its rulemaking authority under the Home Ownership Equity Protection Act to curb abusive lending practices without discouraging responsible subprime lending.

The strains in financial markets that were so evident and worrisome in mid-September appear to have lessened somewhat. During the past few weeks, as market participants have gained a better understanding of their financial positions and the positions of others, financial markets have become more stable. The Federal Open Market Committee meets again on October 30^th and 31^st, and we will once more assess developments and act as needed to foster price stability and maximum sustainable economic growth.

A weak December employment report, combined with a falloff in retail spending and flat industrial production, supports my view that the economy has shifted to a lower growth track. Although I expect that the restraining influences to growth will diminish over time, and that the economy will gain firmer traction later this year and into 2009, I am concerned about the downside risks to that outlook.

Of course, I know that our economy is confronting a number of challenges as the new year begins. The residential real estate market still appears to be in freefall. In addition, oil prices have risen, and housing and equity prices have fallen. These factors are restraining the economy beyond the housing sector.

Even as economic growth was slowing, inflation at year-end was clearly elevated. Rising energy prices were a big part of the increase in overall inflation, and some of those costs were passing through to the core inflation measures as well. So, too, the falling dollar seems to have boosted import prices. But I continue to believe that the economy's inflation trend will move lower over the forecast horizon as the growth rate of the economy slows and the influence of energy and import prices diminishes.

We have new information about what the future is looking like, and therefore we need to respond to that incoming information about the
future -- not the past, not the current environment but the future.

From audience Q&A as reported by Market News International

If we want to slow the stock market in terms of technology stocks, or slow the housing industry, we don't have tools for doing that. We have tools, a blunt instrument, that impacts economic activity six to eight months out and impacts inflation 18 months to two years out, so targeting it to a specific industry is just very complicated.

From audience Q&A as reported by Market News International

Since our last meeting in December, economic conditions have weakened.

From audience Q&A as reported by Market News International.

For most of our history, the Federal Reserve did not announce any policy moves, choosing instead to let the world guess at our policies by carefully reading the financial market indicators. But gone are the days when central banks find it advantageous to operate in secret.

There will come a time when we will turn the corner on this difficult period. As long as we regulate wisely and do not suffocate our credit markets, the very real hardships of adjustment will fade, and we will all benefit from the new practices that emerge.    

Economic activity slowed sharply last quarter, and that softness has clearly spilled over into the current quarter. The projections I made at the end of January show sub-par economic growth over the near term as the fallout from residential real estate deepens, further straining financial markets and disrupting the flow of credit to businesses and households. Over time, I expect these restraining influences to diminish. I also project that economic slack, combined with a leveling off of energy and commodity prices, will help to bring inflation down from its recently elevated readings to a level consistent with price stability.

The current economic environment is exceptionally fluid, and the economy faces some substantial risks. The Federal Reserve is committed to addressing these risks as we remain focused on achieving our dual mandate of price stability and maximum employment.

The most recent economic projections made by the Federal Reserve Board members and Reserve Bank presidents, which were submitted in January, show a central tendency for real GDP growth this year of 1.3 to 2.0 percent.  ...

The central tendency projection for core PCE inflation in 2008 is 2.0 to 2.2 percent, revised up from 1.7 to 1.9 percent projected in October. However, the FOMC participants' projections call for inflation to moderate over the next two years. Overall PCE inflation is projected to decline from its current elevated rate, assuming that energy and food prices flatten out. This measure is projected to return to a range of 1.7 to 2 percent in 2010.

Those are the projections of the FOMC participants, and the projections that I submitted in January fall within those central tendency ranges.

We have good reason to think that current financial strains have substantially slowed the pace of economic activity.

The most prominent financial-asset-based measures are derived from Treasury Inflation Indexed Securities, commonly known as TIPS. These securities give the investor a fixed real return because their principal and interest payments are tied to the CPI. Regular Treasury securities are not tied to the CPI so breakeven inflation, the difference between nominal Treasury securities and TIPS, is used to infer expected inflation over length of the contract. However, it is difficult to extract a clean measure of inflation expectations from breakeven inflation. Two prominent problems are inflation uncertainty and liquidity risk.

A rise in inflation uncertainty is distinct from a rise in inflation expectations, although both impose costs on the economy. Rising inflation uncertainty - or, in other words, a widening in the range of plausible inflation outcomes - introduces a risk in making long-term contracts, particularly financial contracts. Investors look to be compensated for this risk, as they would for any other risk, making the terms of financial contracts more costly than they would be otherwise.

The second problem - liquidity risk - arises because the liquidity characteristics of the regular Treasury markets and the TIPS markets are not the same. The regular Treasury market is broader and deeper. So in periods of financial stress, such as those we have witnessed lately, large flights to quality might create a downward bias in breakeven inflation as a measure of inflation expectations.

Perhaps a more straightforward way to gauge inflation expectations is to simply ask people their views on inflation. In fact, the University of Michigan's monthly survey does just that. Unfortunately, we have problems with interpreting this data. For one thing, households' beliefs about future inflation are typically much higher than the actual inflation rate. Also, people are likely to report their inflation predictions in terms of whole numbers, and particular whole numbers at that. On average, women also tend to have higher inflation expectations than men, the poor higher than the rich, and the young and elderly higher than the middle-aged.[2]

These patterns in survey responses lead many to question the accuracy of using them to measure inflation expectations. When you get right down to it, they underscore the fact that we really know very little about how people form their inflation expectations. Economists at the Federal Reserve Bank of Cleveland, like many others, are pursuing research that seeks to better measure the inflationary expectations of households and businesses and to shed some much-needed light on the process by which inflation expectations are formed.

Until that time, I am left with the data I have in hand. Both the TIPS-based and survey-based measures of inflation expectations seem to have been fluctuating in a stable range during the past couple of years. In other words, inflation expectations appear to be anchored.

Because credit contractions can emerge and spread rather quickly, the central bank must be prepared to act in an aggressive and timely manner to counteract their effects. And indeed, the Federal Reserve's policy actions since last August have been designed to ease the strains in financial markets and to counteract a projected weakening in economic activity.

So a key assumption underlying my 2008 projections is that economic activity is, in fact, highly vulnerable to a significant credit crunch. Because credit crunches can restrain economic activity through channels that are not fully captured by econometric models or historical experience, my forecast builds in a slower growth trajectory for consumer spending, residential investment, and non-residential investment than the model would have called for otherwise. These adjustments, of course, are only an educated judgment. A credit crunch could impose even more restraint on economic activity, presenting a downside risk to my baseline projection.

"I am not forecasting a recession, but an economy that is going to grow slowly" with "downside risks," Pianalto said.

"It's the credit crunch that I currently see that prolongs the slowing" in the economy, she said.

From Q&A as reported by Market News International

The question is, do we need to have the same amount of information about their conditions.

From audience Q&A as reported by Market News International, referring to non-bank primary dealers now that they have access to Fed emergency lending facilities.

Collectively, these innovations provide for much longer terms of lending, broader types of collateral, a wider class of counterparties, and a tighter spread between the primary credit rate and the target federal funds rate. All of these innovations are designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for promoting financial stability and economic growth.

As financial markets have changed, it's appropriate for us to step back and review whether the regulatory structure we have in place is keeping pace with the changes that are occurring in financial markets.

From audience Q&A, as reported by Market News International and Reuters.

These are challenging times for our economy and financial markets. We know from studying economic history that booms are often followed by busts, and this pattern has repeated itself in our housing markets lately. However, we also know that these stressful periods will abate and that our economy will improve over time.

...[G]lobalization requires us to expand the amount of information we consider in our policy-making process. Second, our ability to accurately interpret price statistics affects our ability to communicate effectively with the public. Effective communication helps us anchor inflation expectations. Lapses in our ability to convey accurate and timely information about the underlying nature of price changes can create uncertainties about central bank objectives, damage our credibility, and impose costs on the economy. 

Inflation is always a home-grown, monetary phenomenon that is ultimately under the control of a central bank. How quickly inflationary impulses filter through to wages and prices, however, depends on many things—most importantly, on the state of inflation expectations and on the degree of slack in an economy. When the public generally anticipates inflation and when an economy is operating at full capacity, monetary excesses can quickly translate into higher prices and wages.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote growth over time and to mitigate risks to economic activity. I know that some observers are saying that this strategy introduces other risks. For example, some individuals question whether by lowering our policy rate in the face of price pressures, we put at risk our goal of keeping inflation low and stable over the long term.

While even the core price measures in the United States are rising somewhat faster than I would prefer, and inflation presents a key risk to my outlook, I believe that the Federal Reserve’s policy strategy remains compatible with a low and stable inflation rate.

Indeed, we have recently witnessed food riots in some developing countries. While sometimes devastating, these global relative-price pressures are not the same thing as inflation.

(J)ust from my personal perspective, I’ll consider us to be back to normal when the Federal Reserve returns to the back pages of the paper’s business section... But we are not there quite yet. And even when markets return to what is typically thought of as “normal,” changes will still be needed for the long term. We need to focus on the factors I cited as causes of the turmoil—lax underwriting standards, complex financial products, and excessive leverage.

Collectively, the information I have been looking at tells me that the economy is now in a recession, although the National Bureau of Economic Research, the referee in such matters, has yet to call one. Nationally, employment has been declining all year, and in last week’s employment report we saw the characteristic monthly employment losses that are associated with a recession.

My last speech here in Columbus was in June of last year, to a group of bankers... Given the spike in oil and commodity prices at that time, we were also keeping a vigilant eye on what seemed to be a potential rise in inflation. A lot has changed in nine short months. The economy has worsened significantly, and we are now concerned about an unwelcome disinflation.

The surest sign that a recovery is on its way and that financial markets are on the mend will be an inflow of private capital into the banking system and a broad-based increase in bank lending. Since the beginning of the year, we have seen declines in commercial and industrial loans as well as loans for commercial real estate. On the other hand, consumer and residential mortgage loans are again increasing, particularly for refinancing. As economic conditions stabilize, more households and businesses will have the confidence to borrow, and more borrowers will become better credit risks. Both developments will contribute to economic growth.

It is natural to equate the problems in our financial system with the securitization of subprime mortgages. But the securitized subprime market happened to be the epicenter, and we now see that the fault line really ran for a very long distance and spanned many markets and many kinds of financial institutions – particularly those that were the most complex and the most interconnected.

I expect economic conditions to stabilize by the end of the year and then begin to recover next year as the fiscal stimulus boosts spending and as we work off excess inventories.

Let me be clear that I do not think that we should rely on regulation, by itself, either at the micro- or macro-level, to prevent future crises. Markets can provide very effective discipline on the decisions of financial market participants. Any new regulatory framework should be designed to work with, and not supplant, market forces.

I propose a framework that I will call “tiered parity.” In this framework, I would construct a small number of tiers and assign each financial company to one of the tiers based on the complexity of its operations and the degree of risk it poses to the financial system. For example, a three-tiered framework could have categories labeled “noncomplex,” “moderately complex,” and “systemically important,” with corresponding degrees of regulatory requirements and supervisory oversight. Where an institution is placed could depend on the situation at hand. Some hedge funds, for example, might deserve closer scrutiny during an asset boom or commodities squeeze, but less oversight during normal times.

As I envision it, one or more financial regulators would have the responsibility, accountability, and authority to identify and mitigate risks posed to the entire financial system. This means making sure that systemically important financial institutions have proper supervision, but it also means looking at possible linkages among firms and at market practices that might pose systemic risk, such as the design and distribution of asset-backed securities and the organization of the credit default swap market.

I do not mean to imply that regulation should punish firms for being efficient and innovative. Instead, it should offset or remove any advantages to becoming systemically important in the first place, perhaps encouraging some institutions to shrink, become less opaque, or lower their risk profiles.

For years, we have been able to finance a large share of our budget deficits with relatively cheap capital from abroad, and for years this has worked to our benefit. But our country should not regard international capital markets as a bottomless well. As access to this well becomes more limited, the cost of financing our fiscal deficits could rise.

[A]s people come to grips with the fact that their finances are more uncertain than they had ever thought they would be, they are not likely to resume spending at the pace they once did. As a result, we should not expect consumer spending to return to the 70 percent share of GDP that it posted just before the recession began.

[I]t is always a challenge to pinpoint when the economy will transition from recession to recovery and to the expansion beyond.
...
In my view, the steep decline in our economy has begun to moderate, and I expect sales and production to begin to recover, although gradually, during the second half of the year. Currently, a lot of attention is focused on the date when this recession will end, but not enough attention is being paid to how much ground we will have to cover before we return to our pre-recession level of economic activity.

Once the recession ends, we may be tempted to hope that the economy will take off at a full gallop, but that is not likely to happen because of some long-standing imbalances within our economy. Addressing these imbalances may result in a slower, lengthier recovery period, but doing so will increase our ability to achieve sustainable economic growth over the longer term.

So, in the near term, resource slack is likely to depress core inflation measures, but over the medium term, stable inflation expectations will play a larger role. Nevertheless, some people still believe inflation is a serious risk based on the expanding U.S. fiscal deficit and the unprecedented actions taken by the Federal Reserve. These critics point to the large size of the Federal Reserve’s balance sheet, and they question the FOMC’s willingness to raise rates when the time comes to do so. They also cite concerns that the Federal Reserve will succumb to political pressure, and monetize the federal debt.

I have to tell you that I do not share these views. As the minutes of the recent FOMC meetings reveal, a variety of tools are being developed to ensure "that policy accommodation can ultimately be withdrawn smoothly and at the appropriate time." Without going into all of the details, I believe that the Federal Reserve has the tools necessary to manage the balance sheet, to make any needed changes in short-term interest rates, and to ensure that our purchase of Treasury securities is consistent with our dual mandate of price stability and maximum sustainable economic growth. When the time comes to start removing our policy accommodation, I am confident that we have the tools and the will to get the job done.

[I]t is far too early to celebrate.  Our economy has, without question, taken a staggering blow...  [However], I do detect a sense of optimism about the economy that I was not hearing a few months ago."

Economic conditions have certainly improved since the beginning of this year, but resource utilization levels still remain low, bank lending is restrained, and credit terms are tight. I expect our recovery to be a gradual and bumpy one. 

The Federal Reserve also has responsibilities for banking supervision. In our capacity as a bank supervisor, we have joined the nation’s other bank regulatory agencies in issuing new guidance on small business and commercial real estate lending. What's really important about this new guidance, I think, is how it encourages bankers to work with their customers during periods of stress... We are trying to be prudent but reasonable in assessing bank managements’ handling of troubled loans. We do not want overzealous supervision to create additional problems for bankers and their customers.

We're independent — there is no constituent that is requiring us to vote for political reasons one way or another. We're voting based on our judgment of how the economy is going to unfold and to meet the two mandates that we have, and that is sustainable economic growth and price stability. Making that process political, I think, would be devastating to our country. Financial markets around the world would become concerned about the credibility and integrity of our system and economy.

Combining [my expectation of subdued inflation over the next few years] with my outlook for a gradual recovery warrants maintaining exceptionally low levels of the federal funds rate for an extended period.

Combining [the expectation of subdued inflation] with my outlook for a gradual recovery warrants maintaining exceptionally low levels of the federal funds rate for an extended period. Still, the time will come when it will be appropriate for us to begin removing some of our policy accommodation. It is always a challenge to get the timing right, because our policy decisions have to be forward looking. And the process will be more complicated than usual this time.

While the size of a specific financial firm is an important factor, it is only one of several factors that should be considered. Other important factors that need to be considered are contagion, correlation, concentration, and context—what we at the Federal Reserve Bank of Cleveland refer to as “The Four C’s.”

Contagion can be thought of as the “too interconnected to fail” problem. If an institution is connected to many other institutions and firms—through loans, deposits, and insurance contracts, for example—all of those firms may collapse if the first firm fails.

Correlation can be thought of as the “too many to let fail” problem. Institutions may engage in the same risky behavior as many other institutions, and the failure of one institution may result in the closure of all those institutions engaged in that same practice.

Concentration can be thought of as the “too dominant to fail” problem. In these situations, an institution has a market concentration sufficiently large that its failure could materially disrupt or lock up the market.

Context can be thought of as the “too much attention to fail” problem. Because of market conditions and other conditions that exist at the time, the closure of a particular institution may cause panic and result in the impairment of other firms.

Thinking about systemic importance in the context of these four factors results in a more reliable and comprehensive identification of firms that, in and of themselves, may be considered systemically important for reasons beyond just their size. Size is a necessary, but not sufficient, criterion upon which we should determine systemic importance.

 Recent evidence I am seeing puts momentum on the side of disinflation, at least in the short run.

For the next couple of years, I expect employment levels to remain well below what I would consider full employment. Similarly, I expect inflation to only gradually drift up from its currently low level but nonetheless remain subdued. In my view, this outlook warrants exceptionally low levels of the federal funds rate for an extended period of time. That said, there is more uncertainty than usual around my outlook, so it will be critical to monitor incoming information and respond as necessary to promote economic recovery and price stability.

Our research has led us to understand that the housing market collapse is the result of a destructive cycle that feeds on itself. In our region, mortgage delinquencies led to a high number of foreclosures, which led to an oversupply of housing, which led to home prices depreciating and borrowers and financial institutions taking on big losses.

To break this cycle, a coordinated set of policies is needed to target multiple points of the breakdown in the housing market.

While the economy is growing, and I expect that it will continue to grow next year, the current pace of growth is not fast enough to make much progress in lowering the unemployment rate.

Economists at my Bank have studied this question, and they conclude that most of the rise in unemployment our country has experienced is cyclical. If there has been any rise in the natural rate of unemployment, it is likely to be small. Put another way, the most important reason employers are hiring so slowly is that their business activity has been slow to pick up, not because there has been a sudden mismatch between worker skills and available jobs.

Pianalto said after her speech that while the Fed is mindful of world economic developments, it doesn’t coordinate policy with other central banks and acts according to domestic mandates.

As reported by the Wall Street Journal.

[W]e are seeing signs that the overall economy is gradually improving. Manufacturing continues to expand, export activity has risen, and companies are investing in equipment again. Consumer spending also finished on a positive note last year. But we are still facing some headwinds. In particular, the housing market remains depressed, which weakens household balance sheets. Also, income growth is likely to be constrained by high unemployment rates, and credit conditions remain tight, especially for some small businesses. Keeping these factors in mind, I expect that the pace of economic growth for this year will continue to be moderate.

I expect the underlying trend in broad consumer prices, which is currently quite low, to rise only gradually toward 2 percent by 2013.

With the potential for inflation expectations to be more volatile in the face of energy and commodity price shocks, I think it could be an opportune time for the FOMC to be more specific and publicly announce an explicit numerical inflation objective. Establishing an explicit inflation objective would clearly communicate our policy intentions and affirm our resolve to achieve price stability. It would also help the public to better evaluate the effectiveness of our actions as events unfold.

With the potential for inflation expectations to be more volatile in the face of energy and commodity price shocks, I think it could be an opportune time for the FOMC to be more specific and publicly announce an explicit numerical inflation objective.

Adopting an explicit numerical objective would have to be the decision of the whole FOMC. My own preference is 2 percent over the medium term, an inflation objective that is quite similar to the targets of many central banks around the world.

Based on the behavior of the median CPI, I don’t expect recent rises in food and energy prices to cause a broad spillover into a wide array of consumer prices, or in other words, a lasting increase in inflation. Specifically, I expect the underlying trend in broad consumer prices to rise only gradually toward 2 percent by 2013.

Given my outlook, I think that the current stance of monetary policy, with short-term interest rates close to zero, is appropriate and supports the FOMC's dual mandate of price stability and maximum employment. In fact, my outlook for the economy that I have been discussing is based on the Committee keeping the federal funds rate close to zero for an extended period of time.

Nevertheless, monetary policy will eventually have to become less accommodative, and we have been developing the tools that we will use to exit from our current policy stance. I am confident that we will be ready to use them when the time is right.

I don't view high unemployment as the "new normal," but I also don't see it as a quickly resolvable problem either... I anticipate it could take about five years for unemployment to reach its long-run sustainable rate of 5-1/2 to 6 percent.

I believe inflation will be temporarily elevated this year due to developments in oil and food prices, but I expect inflation to fall back below 2 percent in the next couple of years.

“With my diminished outlook for economic growth, and my outlook for inflation to soon fall back to 2 percent, I was in favor of providing additional support to the recovery at last week’s FOMC meeting,” Pianalto said today in a speech in Columbus, Ohio.

“Under the circumstances, I think it made sense to take the unprecedented step of including that conditional guidance in our press statement,”

I am fully supportive of the actions the FOMC has taken and feel we are running the appropriate monetary policy based on the outlook we have for both growth and inflation.

Some people think that our recent recession has impaired our labor markets, and that we must accept permanently higher unemployment rates -- that is, we have seen a rise in structural unemployment. I can understand why employment in homebuilding, for example, will not return to pre-recession levels for a very long time. And it is true that some skill sets of the unemployed no longer match well to those skills currently needed by employers. However, based on research from my staff, I think the most important reason for our high unemployment rates is that spending by consumers, businesses, and government still remains uninspiring. In other words, these higher rates of unemployment are predominantly cyclical in nature.

Our policy is appropriate in this economic environment; it is supporting a stronger recovery while ensuring that inflation remains consistent with our mandate.

In today's monetary policy environment, it is a lot harder to calibrate exactly how accommodative monetary policy actually is as compared with the norms I am used to from before the financial crisis. While it is true that the federal funds rate has been near zero for some time, some economic policy models indicate that monetary policy should be even more accommodative than it is today. And this is true even after accounting for the large scale asset programs the FOMC has initiated to compensate for the fact that the federal funds rate cannot go below zero.

I have supported our policy decisions, and there is evidence that they have been effective.

Losses in housing wealth have held back consumer spending, sapped household confidence, and reduced the ability of small-business owners to obtain credit. Further, housing issues continue to affect bank earnings and credit quality.

Given this outlook for economic growth, it could take as long as four to five years to achieve maximum employment, which I estimate to be consistent with an unemployment rate of about 6 percent,

At our last meeting in January, the FOMC decided that economic conditions are likely to warrant that we keep short-term interest rates at exceptionally low levels at least through late 2014. I want to be clear, however, that this statement is by no means a commitment that we will not raise interest rates until late 2014. Rather, it is an expression of what the Committee judges to be the earliest time that we would likely raise interest rates based on our current economic outlook. Changes to the outlook could result in interest rates rising either sooner or later than late 2014.

With my current outlook, I think our policy stance is still the one best suited to foster steady gains in output and employment and to maintain stable prices.

If our economy were a Kentucky thoroughbred, I’d say we have moved from a walk to a trot, but we’re far from a gallop.

We need more growth in order for more jobs to be created and for that unemployment rate to come down to the 6 percent rate which I view as maximum employment.

My outlook for both economic activity and inflation relies on monetary policy remaining accommodative. Therefore, I have voted in favor of the FOMC's policy statements and actions, including the statement that economic conditions "are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014." This date is not a commitment; rather, it conveys the FOMC's collective judgment of when economic conditions would warrant an increase in the federal funds rate. If there is a substantial change in the economic outlook, or risks to the outlook, then the guidance would change appropriately.

Some Fed officials had started lobbying for more action before Friday's report that the unemployment rate rose in May to 8.2% and job growth slowed. Others have hesitated to move, but have held the door open to doing more if the economic outlook deteriorates.

One big question they face: Is the outlook actually worsening or have jobs data turned sour temporarily after stronger-than-expected improvements early in the year possibly driven by unseasonably warm weather?

"It could be that these weaker numbers could also be part of the seasonal adjustment pattern in the data," Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, said in an interview with The Wall Street Journal.

Pianalto said she was still updating her forecasts for the economy. But she said Friday's report taken by itself wasn't likely to lead to "a substantial change" in her outlook and thus didn't change her view that the Fed should stand pat. She is in the camp of officials open to doing more if the outlook deteriorates, but not yet ready to do so.

It is possible that these purchases will yield somewhat smaller interest rate declines and may not stimulate economic activity as much as past large-scale asset purchase programs.

Over time, the benefits of our asset purchases may be diminishing. For example, given how low interest rates currently are, it is possible that future asset purchases will not ease financial conditions by as much as they have in the past. And it is also possible that easier financial conditions, to the extent they do occur, may not provide the same boost to the economy as they have in the past.

In addition to the possibility that our policies may have diminishing benefits, they also may have some risks associated with them. I will mention four: credit risk, interest rate risk, the risk of adverse market functioning, and inflation risk. These and other risks are not easy to see or measure, but they need to be taken into account when setting monetary policy…

It is critical that we take these risks into consideration as we make our asset purchase decisions. To minimize some of these risks, we could aim for a smaller sized balance sheet than would otherwise occur if we were to maintain the current pace of asset purchases through the end of this year, as some financial market participants are expecting. This course of action would be all the more attractive if the economic outlook continues to improve, as I expect it will.

To explain this more clearly, if you could picture two lines, one sloping downward, representing the diminishing benefits of our policy actions, and one line sloping upward, representing the rising costs of those actions, we need to think carefully about where those lines will intersect. Those lines will cross at the point where the costs and benefits are equal, and where further policy actions might cause more harm than good. Reasonable people will differ on where that point of intersection may lie, especially given that many of the policy tools we are using are unconventional…

I will conclude by saying that the FOMC’s actions in the current economic cycle have been needed, understood, and generally supported. Going forward, we must take care to balance the costs and benefits of our monetary policy actions, so that we don’t introduce more uncertainty and create problems that hamper our ability to provide a balancing weight to our economy if needed down the road.

The economy is still far from full employment of its resources, and monetary policy still needs to remain accommodative. Undoubtedly, more unforeseen developments, and risks, lie ahead. However, I would like to conclude with an emphasis on the positive. The economy appears to be on a steady, albeit moderate, growth path, and the potential risks associated with our large-scale asset purchases appear manageable at the moment. I would regard a slowing in the pace of asset purchases to be a welcome direction for monetary policy if it resulted from a significant improvement in the outlook for labor market conditions. That outcome could emerge before long, but it still remains to be seen.

Business leaders in my District report being pleasantly surprised by orders and activity levels so far this year.

…

The economy is still far from full employment of its resources, and monetary policy still needs to remain accommodative. Undoubtedly, more unforeseen developments, and risks, lie ahead. However, I would like to conclude with an emphasis on the positive. The economy appears to be on a steady, albeit moderate, growth path, and the potential risks associated with our large-scale asset purchases appear manageable at the moment. I would regard a slowing in the pace of asset purchases to be a welcome direction for monetary policy if it resulted from a significant improvement in the outlook for labor market conditions. That outcome could emerge before long, but it still remains to be seen.

In the U.S., our economy's performance near-term and longer-term will depend considerably on fiscal policy. Fiscal issues have led to across-the-board spending cuts, which are slowing U.S. economic growth in the near term. The challenge is for fiscal policymakers to enact a credible plan that will put the U.S. federal budget on a sustainable long-run path without adversely affecting the recovery. The United States is not alone in dealing with fiscal issues that threaten growth and stability. Political environments in various countries result in vastly different outlooks for fiscal action and economic and monetary policies. In Europe, the picture is mixed, with some euro zone countries advocating for fiscal austerity while others resist. In Japan, the central bank is ramping up monetary stimulus, while other parts of its government have pledged to establish a sustainable fiscal structure. Some countries may lean toward becoming more restrictive on trade, which would endanger global growth. Around the world, countries are facing fiscal problems, and how they address those problems could have real economic consequences.

Today, the U.S. economy continues to recover at a moderate pace, but unemployment remains unacceptably high. Monetary policy is supporting economic growth, but monetary policy has limits. In current circumstances, it would be particularly helpful if fiscal and regulatory policies were among the forces supporting economic growth.

On the domestic front, the United States lacks a universal, near-real-time retail payments option for consumers and businesses. Cash and debit cards are the closest thing to it, but both fall short of fully satisfying business and consumer needs. We have heard from payments stakeholders that there is demand for a better system. At the same time, we are mindful of lessons learned in other countries that implementing a faster payments solution requires years of hard work.

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Businesses and consumers alike have expressed interest in the ability to make last-minute payments of all types. Businesses and governments are drawn to the potential for enhanced cash management afforded by quicker confirmation of good funds. Real-time transactions could reduce fraud losses for banks and businesses. For consumers, a faster and more convenient electronic payments mechanism would be an attractive alternative to checks. As it stands, many consumers today believe that their payments are real-time. Most businesses know all too well that this is not the case.

In fact, I am the poster child for first-generation college students. My parents had the opportunity to attend school only through the fifth grade in Italy. They moved our family from Italy to Akron when I was 5 years old because they knew that their children would have better educational opportunities in America. Even then, it was not a given that I would go to college—good Italian girls at that time often did not earn much more than a high school degree, and they certainly did not move away from home at age 18 to go to college! But I was fortunate to have support from my family and I had the University of Akron in my backyard. I enrolled right after high school, majored in economics, and never looked back.