William Poole

CHAIRMAN GREENSPAN. Welcome, everybody. I especially want to welcome back an old colleague, Bill Poole. I did not realize that the last time he sat in this room was 25 years ago.
MR. POOLE. I was sitting back there along the wall.
CHAIRMAN GREENSPAN. It has taken 25 years to move from there to here?
[Laughter]
MR. POOLE. Baby steps.

I think that many in the market will view the [balance of risk assessments] as essentially a code for the existing tilt language--that, in fact, it will be read as a Committee view about future policy. And it is important for us not to allow perceptions to develop that we're talking in code.

A couple of weeks ago I had the very pleasant experience of touring the Boeing F-18 assembly plant and had about thirty minutes in the simulator for an F-18. I must say I'm a lot happier sitting around this table than I am in an F-18! But in the process of trying to land that plane in the simulator of the aircraft carrier, I ended up producing what the instructor called "pilot-induced oscillation." [Laughter] That means finding oneself wobbling first one way and then the other way. And I think we have some of the same concerns about monetary policy.

We don't want to produce a Fed-induced policy oscillation. I think that is part of our concern. In my view we don't have that situation in front of us for the following reason: Policy is really positioned very much on one side at the present time. Adjusted for risk, the federal funds rate is the highest rate in the market. Back in May when we raised it to 6-1/2 percent, some rates were above and some rates were below. The funds rate was pretty much in the middle and there was room for rates to move substantially in either direction. Right now, if we have a resurgence in the economy, there is room for longer-term rates to rise by 150 to 200 basis points without our doing anything. We're not forecasting a resurgence but if that happens, there's lots of room for rates to rise.  I don't think there's much room for the market to take rates lower. Outside of a recession situation, I don't think one could find in the data a term structure more inverted than the one we have now. So it seems to me that positioning ourselves in the middle requires that we ease a bit. There would still be a lot of room then for rates to rise without a move by us, if it turns out that the economy is about to rebound.

I am quite frankly opposed to giving a deliberate hint of an intermeeting move.  I think that's going to cause us difficulty not only in coming weeks, but well beyond because people will be wondering in the future if an intermeeting action is on our minds.  So, I believe that that would be a mistake.

I must say that I am opposed to intermeeting moves in general in the absence of some compelling new piece of information of the sort that we confronted in the fall of 1998 or some other totally unexpected shock.  In my view, intermeeting moves create the expectation going forward, for many months or quarters to come, that an intermeeting move might be considered.  That adds to the riskiness of the short-run trading environment in the markets, including the equity market.  The presumption is that with greater risk in the market, prices will tend to be lower and expected yields have to be higher to compensate for the greater risk.  So I'm concerned that an intermeeting move in the near future would simply create more problems for us going forward.  I don't think it matters for the longer-run course of the economy whether rates are moved down now or on May 15th.  But an intermeeting move does produce an environment of greater uncertainty about the way in which we will proceed in the period ahead.  So, I must say that I am very opposed to an intermeeting move in the absence of compelling new information.

When thinking about the outlook, I am always well aware that the only sensible stance for me is to be an informed consumer of forecasts. I am not myself an expert forecaster, and do not—cannot—spend enough time forecasting to expect to outperform those who make a living from that occupation.

In the case of the GSEs, the enormous scale of their liabilities could create a massive problem in the credit markets. If the market value of GSE debt were to fall sharply, because of ambiguity about the financial soundness of GSEs and about the willingness of the federal government to backstop the debt, what would happen? I do not know, and neither does anyone else.

Let me throw out for debate two steps the federal government might take to resolve the ambiguity that I see as a fundamental risk to the continuing stability of our financial system. First, various aspects of federal sponsorship that the market reads as providing an implied guarantee of GSE debt should be withdrawn...Eliminating the Treasury's authority to lend to the GSEs would provide a signal that the government is serious when it says that there is no government guarantee of GSE debt.  Second, over a transitional period of several years, the GSEs should add to the amount of capital they hold.

In my judgment, the only way for financial institutions to insure stability in the event of nonquantifiable shocks is for them to maintain a substantial extra capital cushion above that deemed necessary by analysis of quantifiable risks.

Should either [Freddie or Fannie] be rocked by a mistake or by an unforecastable shock, in the absence of robust contingency arrangements the result could be a crisis in U.S. financial markets that would inflict considerable damage

This evidence suggests that government policies toward labor markets can be an important determinant of labor mobility and, consequently, the average unemployment rate and duration of unemployment spells. Most of us would agree that government should provide a safety net for people who become unemployed. However, we must keep in mind that the level and structure of benefits can affect the incentive for the unemployed to seek out new jobs, while high minimum wage rates and high tax rates can reduce the demand for labor.

I confess to feeling very uneasy that money plays practically no role in policy discussions in the Federal Reserve today. I am one of the few members of the FOMC who ever mentions money during the meetings.

The first principle is that the FOMC will not respond to “shocks” that are seen as very transitory. Policy should only react to “shocks” that are longer lasting—highly persistent. The reason for this principle is quite straightforward—nothing that the FOMC can do will offset the impact on the economy of a “here today, gone tomorrow” event. While economists continue to debate exactly how “long and variable” the response of the economy is to a policy action, there is a consensus of professional opinion that it takes at least several months before the economy responds. Of course, judgment is always necessary to determine whether any particular shock is likely to be transitory.

For at least forty years economists have been trying to develop a quantitative characterization of FOMC policy actions—a policy reaction function.(5) A review published in 1990 analyzed 42 published examples of attempts at characterizing FOMC behavior. (6) Since 1993, the prevalent framework to quantify FOMC action is the “Taylor Rule.”(7)

None of these efforts have achieved their objective.(8) In my judgment, it is not possible at the current state of knowledge to define a precise reaction function of the FOMC, and perhaps it never will be possible.

It is possible, however, to describe some general principles that guide FOMC behavior and which can be applied by market participants to form expectations about how the FOMC will respond to new and unexpected information.

I’ll refer to this forecast as the “FOMC members forecast.” The forecast reflects a survey of FOMC members, but is not an FOMC forecast per se because the Committee does not debate and vote on the forecast to make it a Committee forecast as such. Nor is it the Board of Governors staff forecast prepared for each FOMC meeting and reproduced in the Greenbook; the Greenbook is released with the FOMC meeting transcript only after a five-year lag.

There is wide agreement about the necessity of some regulation to protect workers from illegal discrimination or employer fraud. There is less agreement, however, on the extent to which workplace regulations—including minimum wage laws, mandatory severance pay, right-to-work laws and legislated fringe benefits—are necessary. Overregulation of hiring, firing and working conditions can make the labor market too rigid and make businesses reluctant to start up and to hire workers.

When the primary battle against inflation started in 1979, there was a strong case for paying great attention to the rate of money growth as a measure of the thrust of monetary policy. Money growth is not irrelevant to assessing inflation risks today, but the emphasis has changed. For a variety of reasons, and especially because expectations of low inflation are so entrenched in the markets, short-run money growth is an inadequate indicator for monetary policy purposes. What we need to do instead is to extract as best we can evidence of possible inflationary pressures from a variety of other sources of information.

A danger in relying on the FOMC’s own forecasts of its policy direction is that the market will focus on these forecasts and not on the underlying rationale.  Were that to happen, the market will inevitably be surprised when events require policy actions that differ from the FOMC’s own forecasts.

In 2000, the FOMC switched from the “tilt” language to the balance-of-risks language with the explicit intent to avoid signaling future policy actions.  Nevertheless, in August 2003 the Committee added a statement that was intended to give the public some idea of how it believed policy might proceed in the near future.

A policy problem arises because policymakers do not know exactly how monetary policy actions are translated to the real economic variables; policymakers must estimate, or guess, the magnitude of the response of such variables to policy changes and how long these effects last.  The only certainty is that effect of policy actions on real variables eventually dissipates.  “Eventually” may cover a period of several years, and may be longer in some circumstances than others.  It is worth noting that these hedges on my part reflect ignorance—mine and the profession’s—and not obfuscations.  We just don’t have precise estimates of the magnitudes and durations of effects of monetary policy on real variables.

Another important step toward more predictable policy was for the FOMC to confine policy actions to regularly scheduled meetings.  Since February 1994, policy actions other than at a regularly scheduled FOMC meeting occurred only in unusual circumstances.

After the January 2000 FOMC meeting the policy “bias” in the press release was dropped in favor of a “balance-of-risks” assessment.  The statement following the September 2004 FOMC meeting read as follows: “The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal.”  To provide guidance on its thinking, the Committee might assess the risk of achieving one or the other, or both, of the goals to be tilted to the upside or downside.

Adoption of the balance-of-risks language reflected the Committee’s effort to avoid confusion about the interpretation of the wording of the “bias” statement which specifically referred to the “intermeeting period.”  The replacement balance-of-risks statement focuses on providing insight into the Committee’s assessment of the outlook for future real growth and inflation, but falls short of providing a full fledged forecast of the economy...

A small step towards a more explicit statement of the FOMC’s inflation objective was taken in 2003 when, at the May FOMC meeting, the Committee indicated that “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.”  This statement gives a hint about the view of committee members of the lower end of a tolerance range of measured inflation.  At that time inflation, as measured by the Committee’s preferred “core” personal consumption price index, was approximately 1 percent.  To date, the Committee has not addressed the question as to what inflation rate would mark the limit such that a substantial rise in inflation above that rate would be unwelcome.

Moreover, it is important to note that a statement of probable future policy direction may actually be a more important policy decision than the setting of the current intended federal funds rate.  How easy would it be for a member to agree to a policy action on the intended federal funds rate but dissent over the wording of the policy statement indicating a probable future direction to policy?  The FOMC decision process certainly includes the obligation of FOMC members to dissent when they have a fundamental disagreement with the policy decision; that process is well understood today with reference to the decision on the intended federal funds rate.  To maintain the integrity of the dissent process, the public will have to understand that dissents may be in order over the wording of the policy statement, a possibility that has not been widely discussed.

The practice of the European Central Bank differs somewhat from that of the “inflation targeters.”  The ECB offers a degree of transparency with respect to its monetary policy objective—the ECB has an announced goal of keeping the inflation rate close to but below two percent per annum “in the medium run.”  However, the ECB has never announced an explicit definition of the “medium run.” 

Government Sponsored Enterprises (GSEs) specializing in the mortgage market, especially Fannie Mae and Freddie Mac, exposed the U.S. economy to substantial risk, primarily because their capital positions are thin relative to the risks these firms assume...I believe that the capital held by [Fannie and Freddie] should be at a level determined primarily by the cushion required should an unlikely event occur rather than by an estimate of the probability itself. It may be that the highly volatile interest rate environment of the early 1980s is extremely unlikely to recur, but I would like to see F-F maintain capital positions that would enable the firms to withstand such an environment anyway.

I think we certainly could see [price declines] in particular markets, but I don't think it's going to be general nationally and I would be surprised if declines in the particular markets were large.

The risk of financial problems at Fannie Mae and/or Freddie Mac are not as remote as it might seem, because of the fat tails of the distribution of price changes in asset markets. These two observations—enormous potential costs and a probability of failure higher than commonly realized—imply that the risks of very large events must be identified and carefully analyzed through extensive "stress testing."

The Federal Reserve has adequate powers to prevent the spread of a liquidity crisis, but cannot prevent a solvency crisis should Fannie or Freddie exhaust their capital. In the event of a solvency crisis, the market would become unreceptive to Fannie and/or Freddie obligations; they would have difficulty rolling over their maturing debt. Moreover, their outstanding obligations would decline in price and their markets would become less liquid.

Although many investors assume that F-F obligations are effectively guaranteed by the U.S. Government, the fact is that the guarantee is implicit only...An investor who ignores the risks faced by Fannie Mae and Freddie Mac under the assumption that a federal bailout is certain should there be a problem is making a mistake.

[The "measured pace" wording] obviously will be taken out at some point because at some point it will be much less clear what the probable, reasonable, correct direction of interest rates is going to be, so at some point it will come out.  But I think it has served a useful purpose.

The prospect for where the dollar is going to go is completely uncertain...I do not see that the weaker dollar has had any significant impact on the aggregate economy or on the stability of financial markets, or any sort of fallout effects of that sort.

The saving rate [in 2004] probably averaged around 0.5 percent—clearly too low to be consistent with the saving necessary to support a sustainable pace of capital formation over time.

An investor who ignores the risks faced by Fannie Mae and Freddie Mac under the assumption that a federal bailout is certain should there be a problem is making a mistake.

Peering into 2005, it seems likely that labor market conditions will continue to improve and that monthly employment gains will probably exceed by a comfortable margin the roughly 125,000 per month necessary to keep the unemployment rate constant. It’s an open question, though, whether we will return to the days when monthly employment gains of 200,000 per month or more were the norm, as they were during the last two business cycle expansions. Today’s era of higher labor productivity growth and increased globalization may tend to limit employment growth.

Trend productivity growth seems likely to settle down to something around 2½ percent—a respectable estimate of its sustainable rate. In that scenario, real GDP growth of 4 to 4½ percent for 2005 seems pretty reasonable. ... Given all the unpredictable things that can happen, a point forecast of 4 percent growth over the four quarters of 2005 should really be expressed as a growth rate of 4 plus or minus 1¼ percent.

In a market-based economy like ours, the pricing mechanism eventually allocates resources to their most productive uses. Hence, higher oil prices will stimulate both increased production and active energy conservation measures, both of which will tend to limit further price increases and perhaps reduce prices over time.

Recent data, then, suggest that inflation is well controlled. The FOMC has emphasized that it is prepared, if necessary, to move more aggressively to protect the relatively low rates of core inflation that now exist.

Today’s economy can endure periods of sharply higher energy prices that, in earlier periods, might have caused considerable economic disruption. Indeed, one of the remarkable aspects of last year’s economic performance was just how well the economy performed in spite of a sharp run-up in energy prices. Unfortunately, many of those in the business of discussing the U.S. economy seem to underestimate our economy’s resilience.

Augmented by continued strong labor productivity growth, improvements in the labor market, and a recovery in household purchasing power reflecting lower energy prices, growth of consumer spending should also remain healthy.

Given the GDP has been so close to expectation, the slightly slower-than-expected job growth is just the flip side of the somewhat greater-than-anticipated productivity growth.

There are no easy solutions to the problem of how to ensure that our public pension system remains sound in the face of inevitable demographic changes...Still, we must make some changes in our Social Security system to ensure its long-run solvency, and those changes will involve some hard choices.

We will have to either raise the retirement age for the current level of annual benefits, reduce the level of benefits in current law, raise taxes on working persons, or adopt some combination of the three options.

The advantage of moving toward increased use of personal accounts in government pension systems is that it would reduce the taxes imposed on one generation to fund the benefits paid to an older generation...A move toward personal accounts would strengthen the links between one’s contributions and the benefits he or she receives, and thereby lessen the burden of an aging population on the funding of retirement benefits.

Personal accounts will allow people to insulate themselves from the risks inherent in a system that relies on taxing one generation to fund the benefits of another generation.

It is clear that Japan and Europe face imminent demographic challenges. Thus, it is natural that they accumulate claims against a country that has financial markets and economic growth prospects of sufficient magnitude to facilitate the required adjustment process. A case can be made that the current account surpluses of these countries as well as the current account deficits of the United States will be reversed in the future as these aging economies draw on their claims against the United States.

The dollar has depreciated a little bit, but in the scheme of things, the dollar has been pretty stable over the years and yet the current account deficit has risen to historic proportions...The way in which you can make these two things fit together, within a perspective that involves informed market behavior, is this demographic perspective that I tried to sketch today.

Examining current account balances from a demographic perspective is potentially very useful. The intertemporal approach to current account balances is well-grounded in economic theory. Saving and investment behavior are the keys to the evolution of a country’s current account. It is exactly these behaviors that the demographic perspective highlights. Moreover, the fact that many countries, especially those in the developed world, are experiencing major demographic changes suggests that additional focus from the demographic perspective is warranted.

At some time before long, the [measured pace] comment will come out of the statement.  But as long as the economy goes along in such a balanced way, moving in such a nice fashion, I would expect it to remain.... At some point, there may be surprises; new information that will make that language inadequate.

I don't know whether the FOMC will at some point adopt a formal inflation target...[But] I suspect it's going to continue to come up.  I don't think the issue is going to die away.

Although statements in recent years reflect considerable continuity, changes usually come as a surprise to the market, and the initial meaning of new phrases has not always been clear. For that reason, I think the FOMC could improve clarity, especially when policy direction changes, by agreeing in advance on stock phrases to describe different situations.

The [March 22nd] statement emphasized the FOMC’s increased concern over inflation, as evidence is accumulating that firms perceive an increase in their pricing power. From my perspective, the market reaction to that statement made a lot of sense and reflected my own assessment of a changing inflation environment. The changed language in the statement not only explained the 25 basis points increase in the target federal funds rate but also the renewal of the “measured pace” phrase that indicates that the FOMC anticipates further increases in the target rate at future meetings.

The upward thrust to the economy appears quite substantial and the risk of higher inflation over the next six months or so seems clearly greater than the risk that inflation will fall below a desirable range. The aim of monetary policy should be to counter inflation pressures with a less accommodative policy stance, so that higher actual inflation does not extend beyond unavoidable transitory effects.

The future path will be conditional on future information that cannot itself be predicted. Attempts to provide specific forward-looking guidance will prove inaccurate and even misleading to the market. Moreover, the Fed could create a credibility problem for itself if forward guidance is too specific.

I think the biggest unknown is whether the inflationary pressures that are pretty obvious are a temporary thing--because of energy pass-through--or whether we have a larger inflation problem.  I am more in the former group than the latter...Should we see evidence that we are getting into a more fundamental inflation problem, which as I say is not my best guess, you are going to see the Federal Reserve react more vigorously.

Policymakers concerned with entrepreneurship should understand that a tradeoff exists between entrepreneurial growth and taxes. The benefits of additional government programs funded through taxation must be weighed against the costs of reduced economic growth and entrepreneurial activities.

Government should concentrate on providing the fundamental legal and security infrastructure necessary for a democratic society to function, and should avoid detailed regulation of business practices and market structures. As much as possible, we should rely on competitive forces rather than government forces to constrain private power.

A passive policy environment that is friendly to entrepreneurs, and to all businesses, is one that balances the use of regulations and taxes against the burdens that they impose...A good rule might be to never impose a new regulation or establish a new agency without disbanding an old one.

As I see it, there is little reason to modify the output and inflation projections that the FOMC presented to Congress in February.

There's less slack than there was but when you talk to firms you get the sense that labor is in pretty plentiful supply, with the exception of a few specialized areas.

The large increase in employment in April reported on Friday, and upward revisions of employment data for February and March, dispelled much of the soft-patch talk.

I would not be at all surprised if [private GDP forecasts] were marked up in response to the strong April jobs report.

I don't get anecdotal evidence from firms saying they're having trouble finding qualified applicants. It's a lot different than when I first came to St. Louis, which was in 1998 and 1999 ... that suggests to me that the labor market still has a fair amount of slack.

As many analysts have commented, some of the latest data are suggestive of an economic soft patch. I do not disagree with this interpretation, but emphasize that there is so much noise in monthly data that it is unwise to dramatically alter economic forecasts for this year and next.

When we put all the recent data together, we get a mixed picture that does not require a fundamental change to the outlook. Nevertheless, we should not forget the usual forecast errors.

The FOMC will be following incoming data closely to determine whether the recent moderation in economic growth is likely to persist into the summer and beyond.

Productivity growth over the next few years does not take breakthrough scientific or technological inventions, it comes from the application of stuff that's already known.

Inflation pressures may continue to intensify, particularly for prices of non-energy and non-food items. The FOMC will have to sort out whether the data indicate that more rapid price increases are a temporary blip on an otherwise steady long-term outlook or an indication of a more fundamental inflation problem.

On balance, there seems to be a firmer tone to the very latest data, in contrast to the soft texture that characterized some of the previous readings.

Policy will be data-driven when we get data surprises that require a different policy setting..."Measured pace" should not be viewed as an ironclad commitment to a particular outcome at the next meeting.

The FOMC has emphasized that it is prepared, if necessary, to move more aggressively to protect the relatively low rate of core inflation that now exists. Nevertheless, the FOMC’s best judgment at this time is that the target federal funds rate can continue to rise at a measured pace and that this policy will maintain economic growth without rising inflation.

I'm not relaxed about inflation. I don't think any central banker is ever relaxed about inflation. But I don't think there is reason for concern or deep concern or worry, however you want to put it

Looking ahead, I’m optimistic about the inflation situation. Wage inflation remains modest. Productivity growth remains good. The pricing environment remains quite competitive, which means that firms cannot readily expand profit margins. Should any of these factors change adversely...then inflation risks will rise. Although I believe that inflation risks are tilted to the upside, I do not believe that the probabilities are high enough to justify concern at this time.

Although still high, it is useful to remember that current prices would need to rise to around $77 per barrel to reach their record inflation-adjusted highs that were seen in early 1980.

High prices, however, should not be confused with rising prices. Although there may be some continuing pass-through of higher energy prices into prices for other goods, energy itself should not be a source of long-continuing inflation pressure.

My sense is that commodity price pressures have substantially disappeared. You heard a lot, for example, about steel price pressures a while back and I don't think that is so much of an issue anymore...I think those prices have stopped rising on the whole.

It looks like there is a fair amount of room for expansion of employment without creating a lot of upward pressure on wages.

The fact that the 10-year bond has not exhibited a persistent trend over the past 18 months or so while the Fed has been increasing the target fed funds rate by 200 basis points is not evidence that something is awry with monetary policy.  

If real growth and/or inflation depart significantly from current expectations, then we will see a persistent trend in the bond rate.

The Fed ought not to take risks of inflation going higher on a sustained basis.

I do not believe an inverted yield curve will be a sure-fire indicator [of an upcoming economic downturn].

This [global savings glut] factor does not solve the term structure puzzle, for two important reasons. First, as noted, the glut has been in force throughout this decade, while the term-structure puzzle refers to the period since early 2004. Second, the glut is a source of downward pressure on real interest rates at all maturities since 2001, while the term structure puzzle instead refers to the recent flat trend of the long rate despite a significant increase in the short rate.

I have long been of the view that you really need to think of Fed policy on the whole as being driven by incoming data...I would think it would be misleading to the markets to provide firm guidance about the future of policy.

The current low long-term bond rate I absolutely do not view as a monetary policy failure.

I think that the idea of portfolio caps is a good one.

I believe that the current outlook for the economy is quite favorable.

With respect to forecast errors, the future is more likely to be like the past several decades than like the past year.

The real economy has performed very close to expectation at the beginning of 2004. The major surprise has been the large increase in energy prices. The market has interpreted this increase as a relative price change and not a sign of higher long-run inflation.

I do not believe that there is a term-structure puzzle reflected in interest rate behavior over the past year or so. Recent experience is unusual but far from unprecedented.

Future chairmen will address the issue of whether the Federal Reserve should adopt a formal inflation target, which many economists and a number of members of the FOMC, including me, have espoused.

The Fed’s inflation-fighting credibility may be somewhat more fragile over the next few years than it has been over the past few years.

In recent years, market confidence has been so great that only a string of poor policy decisions would have changed inflation expectations.

Providing guidance on likely future policy actions is a significant departure for the Federal Reserve. Historically, the Fed and other central banks have been reluctant to provide forward guidance out of a concern that doing so would limit freedom of action in the event of new information indicating that changed circumstances called for a change in policy direction.

The next chairman will start with a base of institutionalized market confidence, but the market will naturally be somewhat skeptical until the new chairman has established his or her own track record.

In the years ahead, should there be further crises, I believe it is reasonable to expect properly calibrated responses by the Fed. The lessons of experience have been thoroughly institutionalized in Federal Reserve practice.

In the years ahead, maintaining and extending improved predictability of policy will be a major challenge for Federal Reserve chairmen.

The evolution to greater transparency proceeded step by step during the Greenspan years.  The most important single change was that the Fed began to disclose its decisions on the target fed funds rate in 1994.

A casual examination of the target funds rate series will show long strings without change and long strings with changes in the same direction. Short-run reversals have been relatively rare. I believe that this pattern of adjustment probably enhances market understanding of the direction and purpose of policy actions, helping to improve the predictability of policy. When the central bank is predictable, it can be somewhat inactive as market responses carry much of the stabilization burden.

Experience to date with forward guidance has been successful but in my opinion it is too early to tell whether this departure will be successful in the long run. The matter will be tested when changed circumstances require policy action that differs from forward guidance.

I think it's incompatible with a market economy to have a government agency setting asset prices.

Market confidence in the Federal Reserve’s ability and willingness to maintain a low trend rate of inflation has been a core characteristic of the Greenspan regime...Examination of current survey data and the spread between the yields on conventional and indexed Treasury bonds indicates that market confidence in continuing low inflation extends well beyond Greenspan’s tenure as Chairman. Institutionalizing market confidence in the Federal Reserve is a great accomplishment.

The economy is robust and it will be able to grow at a pretty good pace and inflation should remain in the neighborhood it is in even if we get some adverse surprises.  I think the economy is on a very firm footing.

The market is anticipating the funds rate is going higher and I respect the market and that is a reasonable expectation.

If we see, over the next six months, growth on the high side and inflation on the high side, it's logical that Fed funds [rate] increases will continue for longer than might otherwise be the case.

The economy will function more efficiently if the markets and the Fed are interpreting incoming data the same way.  If the Fed and the markets have the same view as to the policy implications of new information, then the market will be able to predict Fed policy adjustments accurately.

Policy decisions, whether or not including a fed funds target change, taken at regularly scheduled FOMC meetings, particularly since February 1994, have generated little if any news in the federal funds futures market.  Such decisions have been well anticipated by market participants.

Market sentiment has coalesced around the view that news about employment growth is a significant influence on the path of the intended funds rate in the forseeable future...My emphasis on market reaction to employment surprises does not mean that the market ignores inflation.  What has happened in recent years is that core inflation--inflation excluding effects of food and energy--simply has not generated significant surprises.

The federal funds futures market and other markets...provide a rich source of information to better understand the effectiveness of the Fed's changes in disclosure policies over the Greenspan era.  It is quite clear that the markets understand Fed policy to a much greater extent than before.

Capital flows are driven by a number of economic forces which are not fully understood, especially at a quantitative level. The “home bias” of investors, which has led them to invest in their home countries rather than seek optimal international diversification, has probably been diminishing and as a consequence investors everywhere are increasingly investing outside their home countries. Countries with rapidly aging populations, especially Japan and Western European ones, may be saving and investing in the United States against the day when their populations will be drawing down assets to support retired citizens. Because the United States economy has been growing at a faster pace than most high-income counties, investment returns from U.S. operations have tended to exceed those abroad, thus encouraging capital flows to the United States.

[T]he question is not whether the U.S. current account deficit will fall in the future but whether the inevitable adjustment is likely to be painful and disruptive of U.S. economic growth and stability—a hard landing.

My answer is that a hard landing is very unlikely provided that U.S. monetary and fiscal authorities maintain sound policies.

Higher energy prices are a change in relative prices that will inevitably lead to changes in other relative prices--an increase in the price of gasoline relative to other goods and services, for example, affects SUV prices and sales.  Energy price increases will affect other prices, at least for the medium-term, but should have little impact on longer-run inflation expectations.

I would offer a word of caution, however, regarding over-interpreting market-based expectation measures. Paradoxically, if the Fed ever becomes perfectly credible with respect to its policy goals, the resulting credibility will destroy the information flowing back to it from financial markets: whenever the Fed looked into the mirror of the private sector, it would see reflected back only it own image. It is for this reason that I have emphasized that policymakers cannot relax—we need to do the best we can digging into information of all sorts to provide the clearest possible view down the road so that policy adjustments preempt inflation.

Although predictable policy—the body language—is the most important feature of the current situation, improved policy communication has also played a significant role. Perhaps the most important step the FOMC has taken to improve policy communications was the release of the policy decision immediately following each FOMC meeting, starting in February 1994. Other steps, such as more timely release of minutes of FOMC meetings, have been helpful.  I believe that there is a consensus that better communication furthers the goal of informing the markets more completely about the course of monetary policy, enabling market participants to make more efficient decisions...As every central banker knows and has most likely experienced, communication is difficult because it is so easy to be misunderstood. Miscommunication adds uncertainty and creates market volatility...Increased attention to communication has a benefit that is frequently overlooked—an improvement in the clarity of internal deliberations. In a committee context, explicit understanding of policy goals and agreement on policy direction must precede public communication. We need to know what we want to say before we try to say it.   

Central bank credibility is an aspect of the broader issue of trust. Credibility and trust, once lost, can be extremely expensive to regain. I believe that most policymakers recognize this fact, and the recognition has much to do with efforts to enhance transparency to build trust.

Historically, the Federal Reserve has not provided forward guidance for fear that it would lock itself into a policy stance that might, under new information, no longer be appropriate. In principle, there is no reason why the Fed cannot explain the nature of the conditionality and convey the view that policy guidance depends on information available at the time guidance is offered.

Although the Federal Reserve has not announced a numerical inflation target, Ben Bernanke, the nominee to become Fed chairman in February, is on record favoring such a target. Although I am also on record favoring a formal numerical target, I believe the issue has not been a large one in the United States. Many observers believe that the Fed has been pursuing an inflation target range of 1-2 percent annual rate of increase of the core PCE price index. If the Fed does adopt a formal target in the future, I doubt very much that statistical tests for a regime break would be able to find one in an economic series such as an inflation index, employment or real GDP.

I anticipate that the adoption of a formal inflation objective would result in some, probably modest, further reduction in the level and variability of nominal long-term bond yields.  Adopting a formal inflation objective, and success in achieving that objective, will also enhance policymakers’ ability to pursue other policy objectives, such as conducting countercyclical monetary policy.

The inflation-targeting framework provides a vehicle, or structure, within which the FOMC can better explain its monetary policy actions and the policy risks it must face. Inflation targeting should increase accountability not so much by keeping score of target hits and misses but rather by encouraging a much deeper understanding of how monetary policy decisions are made.

In the early 1960s, as today, the Fed enjoyed a high degree of market confidence and inflation expectations were low. At that time, only a small minority of economists thought that monetary policy was “broken” in any important way, and thus the case for “fixing it” was minimal. Would a formal inflation target in 1960 have been an ironclad guarantee that the Great Inflation would never have happened? Surely not. Would it have helped? I believe that the answer is surely yes.

A specific target range, such as 1 to 2 percent annual change in a particular price index, has the advantage of focusing attention on low-frequency inflation. Even here, there could be special circumstances, which the Fed should explain should they occur, that would justify departure from the target.

Should the FOMC announce what its inflation objective is? Answering this question is simple in principle. If announcing a specific, numerical inflation objective enhances the efficacy of monetary policy, then the answer is yes. If doing so reduces the efficacy of monetary policy, the answer is no. I believe the answer is yes .

Allowing as best we can for measurement bias, which might be in the neighborhood of half a percent per year for broad measures of consumer prices, I favor literally zero inflation. Given measurement bias in price indexes, I might state my goal as inflation between 0.5 and 1.5 percent as measured by the price index for personal consumption expenditures (the PCE price index).

Another explicit understanding could be that all policy adjustments will be in increments of 25 basis points, unless compelling reasons argue for larger moves.

An increase in the intended rate of 25 basis points between scheduled meetings has a very different meaning than the same size increase at a scheduled meeting. To reduce uncertainty over the meaning of intermeeting policy actions, the FOMC could adopt an explicit policy of making all policy adjustments only at scheduled meetings unless there were a compelling circumstance to act between meetings. The compelling circumstance ordinarily could be easily explained; indeed, the event triggering a policy response would probably be highly visible and the policy response occasion no market surprise.

Asymmetric information. A feature of many market environments is that some agents in the market have more information than others do. In the monetary policy context, the Federal Reserve has the largest and most extensive economic information gathering system in the world.  The Fed not only has a large staff but also has access to considerable confidential information from individual firms. To some extent this confidential information can be disclosed in summary form without identifying individual firms, but nevertheless the Fed’s timely access to this information and knowledge of the firms involved does give the Fed an advantage over the market in general.  However, the information asymmetry is not totally one-sided.  Individual firms have enormous specialized market information that the Fed does not have. For example, large retail firms have day-by-day and even hour-by-hour information on the scale of retail transactions in the economy; large banks and credit card companies have information on day-by-day economic activity as they observe flows of transactions on their own books.  The relevant economy-wide reports constructed by government statistical agencies come out with a lag measured in weeks to a month or more.  These formal statistical reports are the primary source of Federal Reserve information, and they are available to everyone in the market.  Although there certainly is an issue of asymmetric information, my own view is that asymmetric information is not a major issue for Fed communications policy.

Transparency must mean disclosing as much as possible without damaging the integrity of policy deliberations.

Much of the FOMC deliberation consists of fairly technical discussions. Without an advanced degree in economics, or extensive policy experience, much of this material is simply incomprehensible...  Moreover, a certain amount of communication during an FOMC meeting is nonverbal... The thrust of my argument is that the word “transparency” is misleading with respect to Federal Reserve communications challenges.  Instead, the Fed needs a conscious communications strategy rather than a strategy of simply “opening up.”

The full rational expectations macroeconomic equilibrium occurs when the market behaves as the Federal Reserve expects and the Federal Reserve behaves as the market expects... The paradigm of a full rational expectations macroeconomic equilibrium sets the framework for communications strategy. From the Federal Reserve’s point of view, policy effectiveness will be enhanced when the market has a complete and accurate understanding of the Federal Reserve’s goals and policy processes.

As an aside, note that there are policy environments in which a random component to a policy is an essential feature for policy success. Transportation of large sums of cash in an armored truck is an example. The transportation schedule and route should be randomized as much as possible to reduce the probability of theft. To my knowledge, in models of macroeconomic policy no one has created a positive case for randomness.

It is sometimes argued that policy communications should be vague to retain policy flexibility. My own view is that communications should be clear about what is known and what is not.

My hunch, though, is that housing activity will stabilize and remain at a high level this year. I base this forecast on the belief that the FOMC will keep underlying inflation low and stable, and that the growth of real household income will recover nicely due to the waning influence of last year’s spike in energy prices. Continued healthy job growth will also help keep housing conditions at a high level. That said, some slowing in the growth of average home prices nationally seems a reasonable expectation at this juncture

I think that gold has a poor record on the whole in predicting inflation - changes in the rate of inflation. It may well reflect the strong global economy particularly in Asia where incomes are growing handsomely. There's a long history of demand for gold and gold jewelry as a safe - a way of safe guarding assets. That's where it may come from but I'm not an expert on the gold market. I just don't think it has that much bearing on what I do.

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

I like to look at the inflation directly rather than the unemployment rate. If you look at a chart that plots unemployment rate or changes in unemployment rate against inflation there is only the very, very weakest of relationships there. It's just not an adequate indicator for monetary policy purposes in the short run.

I'll tell you at this point, unlike the situation a year ago let's say, at this point I very much go meeting by meeting by meeting. We accumulate the evidence over the course of the weeks between meetings, take it - try to put it all together, look out ahead as best we can and then make the decision at that meeting.

But I myself am not looking beyond one meeting because I think that we are close enough to the region that is an equilibrium. That doesn't say we're going to stop here or that I think we're going to stop here. It doesn't say that I know where my own vote is going to be. But I'm looking at the data one meeting at a time because the information accumulates over time.

...There are always risks on both sides. There are risks that we would stop too soon and there are risks that we would stop too late. And what we have to do is to find the best balance we can between those two risks. I would like - my own view is that inflation is the key here because if - I think we have a lot of evidence that if the inflation rate starts to get away from us that is a much harder process to reverse than if we see the economy softening. Because I believe that the economy would react pretty quickly and constructively to the end of the tightening or even to an easing if it turned out that we saw that in the data. Whereas inflation is a much harder thing to stop once it gets going.

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

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

I remain in favor of [inflation targeting]. It's something that the FOMC is going to be taking up. It's not on the agenda as far as I know right now in the sense of, you know, I don't have a meeting agenda that says that it's there. In fact, I don't have the agenda for the next meeting... I don't believe that an inflation target has any particular bearing on the current monetary policy. I think it has a much longer-run bearing on the Fed and its communication with the market.

I think that there are some differences in the FOMC as to what the desirable target ought to be. I don't think those differences are large but I think they are there. I think we ought to come to an agreement on a common approach because there can only be one target at the end of the day for the central bank...The differences we have across the FOMC I think are pretty minor but we ought to dispose of that issue.

There are two things that we need to do with the language and Fed communication more generally. First, we need to help the market understand how we are likely to respond to various changes that occur in the world, surprises if you will. And part of that comes about as a consequence of explaining our policy actions in response to something that has happened.

Secondly, the Fed ought not itself to be a disturbance to the market. And one of the things that has concerned me is that the language we have used has, I believe, from time to time had multiple interpretations in the market. Now everybody has had the same view of what it is that we said. In fact, I'm willing to bet that not everybody in the FOMC had the same view as to what it is we just said. And that to me is a problem.

I don't think we are communicating clearly if we ourselves don't have the same view and particularly if the market reads different things into what we're saying. So I - and that can be a source of random disturbance to the market which is not constructive so?

[W]e need to draw a distinction between language that says we intend or expect at this time not to change the rate next time. That's a very different thing from saying that we have no commitment at all in our own minds as to what we're going to do next time.

The world economy is very important for certain types of goods. It does nothing, for example, for energy supplies domestically. Think about electricity, the electricity we produce here is not imported from anywhere, maybe a little bit from Canada and Mexico. So there are certain areas of industrial output that are heavily dependent only on local supplies.

Other areas like automobiles would be an obvious example where you can import a lot of goods from abroad. So it varies. Globalization has an important for some parts of the economy but not for others.

We need to find forward- looking measures of inflation. We rely a lot for that on anecdotal reports, for example, contracts that are being signed in advance. We get information from our directors and our business contacts that give us some indication of what's going on ahead. That's part of it. Another part of the story is productivity. Wage growth is fine if it's covered by productivity growth and you don't get it into prices. So we try to look at what's going on with productivity.

I think that there are pockets of tightness in both the physical capacity and the labor market but there are a lot of other places where there's a lot of excess capacity. So I think the economy is on a good solid course and I don't see any reason, in my own view, to say that we're in any sort of difficult situation.

I’ve emphasized the importance of interest-rate expectations for shaping the yield curve and believe that the rate expectations story explains most of what we’ve observed. But there are no doubt other forces at work. It appears that the term premium in long rates fell as the funds rate target increased. One likely reason that the term premium fell in the first year and a half of this tightening cycle is that the market understood the path that short-term interest rates would take in the tightening cycle that began in late June 2004. That predictability reduced the risk of holding longer-term bonds.

Interest-rate expectations reflect investor understanding of how rates will evolve, which is why an inverted yield curve has often preceded business cycle peaks. But the market’s rate expectations also depend importantly on the market’s read of what the FOMC will do. If the market’s expectation does not match the FOMC’s own expectation, then policymakers need to do some soul searching.

Among the international factors cited as influences on U.S. interest rates in the past few years is the global saving glut. Unusually high saving might hold down the level of real interest rates, but there is no reason why there should be an effect on the shape of the term structure. In any event, it appears that real interest rates are returning to a more normal level in the United States.

"If inflation turns out to exceed . . . our target range, I do not believe we can count on a slowing economy to bring inflation down, by itself, quickly," William Poole, president of the Federal Reserve Bank of St. Louis, said in an interview. If inflation expectations rose in "a persistent way . . . we could expect to see that show up in measured inflation in fairly short order." 

In a Wall Street Journal interview

Faced with an uncertain view of the future, the natural tendency of policymakers is to wait for further information on the state of the economy. In the absence of decisive policy actions, central bankers may be able to stabilize long-term inflation expectations by clarifying their vision of price stability.

Such models provide insight into how to conduct monetary policy that will successfully sustain a low and stable inflation environment: the monetary authorities must clearly communicate their inflation policy objectives. The communication must be symmetric: private agents must understand what rates of inflation are unacceptably high and what are unacceptably low to the central bank. Central banks that announce explicit numeric inflation objectives go a long way towards satisfying this communication objective.

Statistical studies to detect pass-through from recent energy price increases have failed to show significant effects in U.S. price data but stories about widespread pass-through are becoming increasingly common. We may—and I emphasize “may” because my purpose is to make a general point and not to conduct a full analysis of the current situation—face more inflation pressure than currently shows up in formal data.

It could well be that we will need additional restraint in the future, but we should not have a clear presumption that we will be raising the funds rate in the future. The decision in August should depend on all the information that we get between now and August, and we should not try to build in a particular assumption on the policy decision. In fact, if I were to be as neutral as I can be on this, I would say something like 50 percent odds that we would hold steady in August and 50 percent odds of another 25 basis point raise. You could take the mean of that and say, “Well, let’s just be done with it today and raise the funds rate an additional 12½ basis points.” [Laughter] But I think that would be pretty silly.

We're going to have to apply all of our analytical skills and our judgment to this decision...[My stance is] 50-50...I'm still totally noncommittal. [Bloomberg]

For over 70 years, since the Reciprocal Trade Agreements Act of 1934, the United States has led the way toward a more open international trading system and I am hopeful that this historic process will continue. Both economic theory and economic history have provided ample reasons showing that changes in legislation and regulation that tilt toward economic isolation are unwise.

I have often noted that my own personal preference is to define “price stability” as a condition in which the rate of inflation, properly measured, is on average zero. I insert the qualifier “properly measured” to point out that actual price indexes may have statistical problems such that zero measured inflation on a particular price index might not in fact reflect a true state of zero inflation. Although my own preference is for zero inflation properly measured, I believe that a central bank consensus on some other numerical goal of reasonably low inflation is more important than the exact number chosen. Thus, I find that recent discussion of a “comfort zone” of 1-2 percent inflation measured by the price index for personal consumption expenditures, excluding the volatile food and energy components, is perfectly consistent with my own thinking.

Finally, price stability is a goal in its own right simply because price instability creates arbitrary and unfair redistributions of income and wealth.

Evidence suggests, particularly in the U.S. economy, that the actual inflation experience is driven by inflation expectations, resource utilization—usually measured by a gap term as in the Taylor Rule—and “supply shocks” such as changes in the world market prices of energy and other commodities.

The Fed’s current mandate, set formally in an amendment to the Federal Reserve Act in 1977 and reaffirmed in 2000, requires the Federal Reserve to pursue three objectives through its conduct of monetary policy. They are “maximum employment, stable prices and moderate long-term interest rates.”  Economists recognize that long-term interest rates incorporate a premium for expected inflation. Thus, the objectives of price stability and low long-term interest rates are essentially the same objective.

Potential GDP has got to be something in the neighborhood of 3% to 3.5% over the next few years.

From Q&A session as reported by Bloomberg News

Note that the target funds rate predicted by the Taylor formula generally tracks the actual funds rate through 2000, though there are sizable and persistent deviations of the funds rate from the values predicted by the formula. Nevertheless several of these episodes are consistent with a systematic monetary policy. First, in 1989 the FOMC increased the target funds rate more quickly than predicted by the formula suggesting that the Committee responded more vigorously to rising inflation than incorporated in the Taylor specification. Second, during 1990-91, the FOMC reduced the funds rate more quickly than predicted by the formula, suggesting a stronger response to the recession than incorporated in the Taylor specification. Third, between late September 1992 and February 1994 the target funds rate was held at a lower level (3 percent) than predicted by the Taylor specification. It was during this period that the FOMC expressed concern about “financial headwinds” that were restraining the recovery from the 1990-91 recession. Finally, in the fall of 1998 the FOMC lowered the funds rate when the Taylor specification predicted that the rate would be held constant. At this time, concern about financial stability figured strongly in policy deliberations in the wake of the Asian financial crisis, the Russian default and the near collapse of Long Term Capital Management, a large hedge fund.

The FOMC, and certainly John Taylor himself, view the Taylor rule as a general guideline. Departures from the rule make good sense when information beyond that incorporated in the rule is available. For example, policy is forward-looking, which means that from time to time the economic outlook changes sufficiently that it makes sense for the FOMC to set a funds rate target either above or below the level called for in the Taylor Rule, which relies on observed recent data rather than on economic forecasts of future data. Other circumstances—an obvious example is 9/11—call for a policy response. These responses can be and generally are understood by the market. Thus, such responses can be every bit as systematic as the responses specified in the Taylor rule.

http://www.stlouisfed.org/news/speeches/2006/08_31_06.html#fig1

In practice, financial market participants and the public in general cannot adequately understand the Fed’s monetary policy—that is the strategic thinking that guides the sequence of individual policy actions—without a good understanding of what the FOMC considers to be an acceptable long-run average rate of inflation. When monetary policymakers articulate their goal for long-run inflation and pursue credible policies to achieve that goal, they provide the basis for “anchoring” the inflation expectations that guide consumption behavior of households and investment decisions of firms. Inflation expectations also determine the inflation premiums in nominal interest rates that are required to bring financial markets into balance...

It is a terrible thing if monetary policy makers lose credibility that they will maintain low and stable long-run inflation. Once credibility is impaired, it can only be reestablished the “old fashioned way”—policymakers have to earn it! Restoring credibility takes time in the face of substantial persistence in the actual inflation process. It took well over a decade to completely restore low inflation in the United States after the Great Inflation of the 1970s, and in the process the economy experienced the worst recession, 1981-82, since the Great Depression.

Unanimous decisions, while desirable, are not required and members are free to dissent from the consensus view if they feel strongly that an alternative policy action is preferable. Indeed, I believe that it is my obligation under the Federal Reserve Act to dissent when I believe strongly that an alternative policy course would be better. Historically, dissents were not unusual though in the recent years they have been relatively rare.

Participants other than the Chairman express their own views in speeches. These speeches often may seem to reflect a “party line” but are rarely centrally coordinated in any way. In my experience, the only time there has been a real effort to coordinate public comments by the participants was in the late summer of 1998. At that time financial markets were skittish as a result of the Russian default and financial troubles of Long-Term Capital Management. I recall an informal gathering in the late summer of 1998 with Chairman Greenspan and a couple of other FOMC members when the chairman made a request that we say very little given the rather tense state of the markets as the LTCM situation unfolded.

But most participants are not shy about expressing their differences. Differences are registered in a formal way through dissents at FOMC meetings, discount rate decisions of the boards of directors of the Reserve banks, which may or may not reflect the views of Reserve bank presidents, and informally through positions stated in speeches.

I don't see, from what I know now, a likelihood of a real inflation outbreak.  Rather, what seems to be more likely is that we will have a persistance of inflation.  what I'm hoping is that it is persistently tapering off, rather than persistently creeping up.

From Q&A session as reported by Bloomberg News

My own personal view is that there is too much emphasis on housing.  It's also true that there's a very substantial boom taking place that many people don't seem to realize in business structures...  That part of the economy is going gangbusters.  The economy, to me, does not seem to be fragile with that kind of activity.

From Q&A session as reported by Bloomberg News

{Monthly payroll gains of 100,000 would be enough to} maintain a steady unemployment rate, taking into account labor-force growth.

From Q&A session as reported by Bloomberg News

Most of the market commentary, I think, is picking up half the story. The commentary is that the economy is perhaps soft and that the next Fed moves will be down on the Fed funds rate rather than up. So the market is anticipating some easing of monetary policy in the future. That's part of the story.

There's another part of the story, though, which is that the bond market works as a built-in stabilizer for the economy.  So the fact that rates are down is going to tend to support housing, for example, which is very, very sensitive, and other consumer durables, interest-sensitive spending.

So the bond market is serving as a built-in stabilizer and will help to keep the economy from weakening dramatically going forward. That's my expectation.

I put the greatest weight by far on the TIPS spread because you observe it daily, hourly if you want. And I don't just trust the surveys. I think the surveys can be influenced heavily by what people are seeing on television, by the latest readings on gasoline prices.

In fact, I wouldn't be surprised with the substantial decline we've had in gasoline prices in recent weeks that you'll see the next surveys coming out down from where they were. But I don't put a whole lot of weight on the surveys.

I think inflation is well controlled. Actually inflation expectations have come down a little bit in recent weeks as the long bond has come down as well.

So to me the inflation environment, although it has a bit of an edge to it and inflation over the last 12 months is certainly higher than I would like, I believe that basically that situation is pretty well controlled.

...I've said before that I am perfectly pleased with a rate that would average in the one to two percent range on the PCE core. And we're a little above that now. I'd rather see it lower. And I think it's going to work its way down.  But not next month but over a period of some months and maybe even some quarters I think it'll work its way down.

[T]he wealth effect is total household wealth. Remember, we've also got equities and bond-market wealth in there. So housing is not the total at all. And the stock market has generally been doing pretty good. 

The wealth effect has also spread out over time. It doesn't produce an instantaneous impact. So it's clearly something we're watching. And we would anticipate that consumption might soften a little.   But I think that's all within the realm of what's anticipated.

On the risk of the Fed losing credibility:  Of course there's always a risk. But we watch pretty carefully and we don't want to see that risk materialize. Certainly as long as I have anything to do with this process I will be pushing hard for a policy that is as tight as it has to be, as disciplined as it has to be, to keep long-run inflation within bounds. And that would be lower than today's inflation.

{Our response} depends on what we know about why {inflation is} hanging high, if that's the hypothesis we're exploring. We need to look at why and we need to look at the various lags in this system.

If we believe that we're headed off in the right direction then we can be patient. We can be patient and sit there and not create a disturbance in the economy. 

Credibility is not, however, one-dimensional. Sustained low inflation is desired for its own sake but even more for the contribution it makes to high employment and economic growth. Thus, while inflation damages credibility, so also can high unemployment. There is a fine balance here. We know that monetary policy cannot affect employment in the long run, but we also know that monetary policy mistakes can create unemployment over an uncomfortably long short run. When unemployment rises, policymakers need to be able to explain in credible fashion why the problem is not a consequence of a monetary policy mistake, for that perception is always present among some observers in such circumstances. There is, after all, some historical justification for such a perception given that almost all economists agree that monetary policy mistakes contributed to the severity of the Great Depression. Given the importance of high employment, a period of sustained excessive unemployment may create doubts about future policy, and this uncertainty is a manifestation of impaired credibility.

In the monetary policy context, research suggests that inflation-forecasting models have not worked very well in recent years. The reason, I believe, is that the Federal Reserve has been pretty successful in exploiting all available public information in its monetary policy decisions aimed at maintaining low and stable inflation.

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

In the past, I have stated my own personal inflation objective as “zero inflation, properly measured” but have also said that FOMC agreement on an inflation objective, which some might express as a “comfort zone of 1-2 percent inflation,” is more important than which precise specification is selected. There are practical difficulties that can and should be addressed, such as what price index to use, over what period to measure price changes and what degree of tolerance to adopt if inflation runs outside the range. I do not believe that uncertainty about the Fed’s inflation objective is a large issue at present but do believe that there is an opportunity to improve clarity.

"Poole said in comments to reporters following his NABE speech that he'd like to see inflation come down over a period of quarters, not years".

Dow Jones Newswires summary of Poole's remarks

I have emphasized the strength of business construction, which is going gangbusters in many parts of the country.  The economy is really not fragile.  It's robust.

In informal remarks to reporters after his speech.

The practical import of this implication for central bank communication policy is that communications should focus on policy fundamentals of goals and the model of how the economy works. The economy works best when policymakers disclose the systematic part of policy and minimize the random part. That is, policy should not itself be a source of random disturbance. In the extreme, austere version of the model I am now discussing, central bank communication about policy responses to individual shocks is unnecessary and more likely to create market disturbances than enlightenment.

A finding of the optimal control literature is that when a policy authority uses all available information as efficiently as possible in pursuing its goals, simple correlations between observable variables and goal variables may go to zero... This is a familiar proposition in the securities markets, where it is stated as the efficient markets hypothesis. Observable information should be quickly reflected in securities prices, leaving no risk-adjusted profit opportunities from trading on publicly available information. There is, of course, an opportunity to exploit nonpublic information.

...The Federal Reserve has an extensive process of gathering anecdotal information from business contacts. Much of this information is published in the Beige Book two weeks before every FOMC meeting. The policy model I’m sketching certainly leaves room for greater and more systematic effort to gather and exploit anecdotal information.

The economy appears to be on a pretty stable course.  Unless we get some large shocks, it is likely that policy adjustments will be relatively modest.

From the Q&A period, as reported by Bloomberg News. 

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

As for 2007, the central tendency of the FOMC members’ GDP forecasts is 3 to 3½ percent. This growth outlook should be consistent with keeping the economy close to full employment, based on the CBO forecast of potential GDP growth of 3.24 percent in 2007.

Although the FOMC itself has not adopted a formal, quantitative inflation objective, several members, including me, have said that they believe that greater clarity about the long-run objective would help both the Committee and the markets to make more informed decisions.

[S]ince World War II, real growth has fluctuated around a 3½ percent average, and forecasts of future growth tend to be centered on that number or perhaps somewhat lower because labor force growth is slowing as baby boomers retire.

In each of the next 16 consecutive meetings, the FOMC voted to raise the target for the federal funds rate by 25 basis points, finally pausing at 5¼ percent in August of this year. It appeared to some that policy was on autopilot, as the FOMC raised the target by 25 basis points meeting after meeting, apparently independent of incoming information. That view, I believe, was mistaken. When the FOMC began the series of rate increases, in June 2004, the statement included this sentence: “Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.” Similar language has appeared in every statement since and the minutes of the meetings have emphasized the same point.  What happened over the 18 months after June 2004 was, basically, that incoming data indicated that the economy was so close to the track expected earlier that there was no reason to depart from the “measured pace” of rate increases of 25 basis points at every meeting.

There are two cases in which the economic news will pretty clearly predict a change in the Fed’s policy stance. If incoming economic indicators show that both output and inflation are rising above {the FOMC's central tendency} forecasts, then in the absence of any other information we can expect that the FOMC will increase its target fed funds rate. On the other hand, if both output and inflation come in weaker than expected, we are unlikely to see further increases in the federal funds target; indeed, if economic weakness is pervasive enough the FOMC will at some point reduce the target funds rate.

Whether the August decision to hold the target funds rate unchanged will turn out to be a pause in the process of raising rates, a longer-lasting stop or even the peak, will depend on the economy’s evolution in coming months.

Policy needs to be as disciplined as necessary to get the job done, but not more so.

I hope that forecasters assign very low probability to inflation outcomes over the medium term of three to five years outside the comfort zone no matter what the incoming data look like...

Still, I believe forecasters should assign a relatively low probability to deep recession precisely because of the FOMC’s demonstrated willingness to act aggressively as necessary. 
 

To say that policy is data dependent means that policy changes will depend on the incoming news about the state of the economy, both real growth and inflation. That the policy setting is data dependent is a good sign. It means that policy is in a range than can be considered neutral—that is, thought to be consistent with the Fed’s longer-run policy objectives.

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

I have said in the past that I thought the policy stance was slightly restrictive.  I think policy can be characterized in recent months as mildly restrictive, not restrictive in any draconian sense.

In comments to reporters after his speech, as reported by Bloomberg News

Asked about Friday’s dramatic upward revision of job creation in the year to March, Mr Poole said his immediate response was to think it would “tend to reduce a little bit estimates for potential GDP growth”.

The Federal Reserve could “sit back” and let the bond market play the role of automatic stabiliser in the economy, even amid concern over the housing slowdown, Bill Poole, president of the St Louis Fed, has told the Financial Times...

“The decline in long rates is working as a built-in stabiliser for the economy,” he said, noting that the fall in bond market rates “will tend to bring down mortgage rates” as well...

"The FOMC can some of the time -- maybe even much of the time -- sit back and do relatively little, relying on the stabilising effect of market reactions to current data," he said.  "We don't have to do it all." 

In the early 1960s, in my Ph.D. studies at the University of Chicago, I was fortunate to be a member of Milton Friedman’s Money Workshop. Friedman stoked my interest in flexible exchange rates, in an era when mainstream thinking was focused on the advantages of fixed exchange rates and central banks everywhere were committed to maintaining the gold standard. Well, I should say central banks almost everywhere, given that Canada had a floating rate system from 1950 to 1962. Friedman got me interested in doing my Ph.D. dissertation on the Canadian experience with a floating exchange rate, and later I did a paper on nine other floating rate regimes in the 1920s. For this paper I collected daily data on exchange rates from musty paper records at the Board of Governors in Washington.

What was striking about the debates over floating rates in the 1950s is that economists were so willing to speculate about how currency speculators would destabilize foreign exchange markets without presenting any evidence to support those views. In this and many other areas, careful empirical research has resolved many disputes.

Ready access to a wide variety of information is essential for transparency and accountability of monetary authorities and a full understanding of policy actions by the public...

Contrast the current situation with the one in 1979. At that time, actions by the Board of Governors on discount rate changes were reported promptly, but there was no press release subsequent to an FOMC policy action and FOMC meeting minutes were released with a 90-day delay. On Sept. 19, 1979, the Board of Governors voted by the narrow margin of 4-3 to approve a ½ percentage-point increase in the discount rate, with all three dissents against the increase. This information generated the public perception that the Fed officials were sharply divided and, therefore, that the Fed was not prepared to act decisively against inflation. John Berry, a knowledgeable reporter at the Washington Post, observed that “the split vote, with its clear signal that from the Fed’s own point of view interest rates are at or close to their peak for this business cycle, might forestall any more increases in market interest rates.”(9) However, the interpretation of the “clear signal” was erroneous. On that same day, the FOMC had voted 8 to 4 to raise the range for the intended funds rate to 11-1/4 to 11-3/4 percent. More importantly, three of the four dissents were in favor of a more forceful action to restrain inflation.(10) Neither the FOMC’s action, the dissents nor the rationale for the dissents were revealed to the public under the disclosure policies then in effect. The result was to destabilize markets, with commodity markets, in particular, exhibiting extreme volatility.

The distribution of economic data by the Research department of the Federal Reserve Bank of St. Louis can be traced back at least to May 1961. At that time, Homer Jones, then director of research, sent out a memo with three tables attached showing rates of change of the money supply (M1), money supply plus time deposits, and money supply plus time deposits plus short-term government securities. His memo indicated that he “would be glad to hear from anyone who thinks such time series have value, concerning promising applications or interpretations.” Recollections of department employees from that time were that the mailing list was about 100 addressees.

Apparently Homer received significant positive feedback, since various statistical releases emerged from this initial effort. Among these were Weekly Financial Data, subsequently U.S. Financial Data; Bank Reserves and Money, subsequently Monetary Trends; National Economic Trends (1967) and International Economic Trends (1978), all of which continue to this date. In April 1989, before a subscription price was imposed, the circulation of U.S. Financial Data had reached almost 45,000. A Business Week article published in 1967 commented about Homer that “while most leading monetary economists don’t buy his theories, they eagerly subscribe to his numbers.”  As an aside, as a Chicago Ph.D. I both bought the theories and subscribed to the data publications.

Every now and then there is a supposed 'revolution' that challenges price stability, but our experience is that policy based on ideas such as that money doesn't matter, or the Phillips curve trade-off, end badly. 

As reported by Market News International

I favor an elastic 'medium term' specification for an inflation target, rather than a specific period such as two years.

As reported in the Wall Street Journal

Earlier, Poole said in response to an audience question that while the housing market's slump may deepen, central bankers shouldn't adjust interest rates unless the slowdown endangers the broader economy.
     ``We just don't know how much further the housing downturn has to go,'' Poole said. ``As long as the housing problem remains confined to housing, there is really nothing the Federal Reserve can or should do.''
     Fed policy makers are now giving the housing market what Poole said is ``special attention.'' Sales of new single-family home sales dropped 23 percent in the third quarter, and Poole said he's concerned about purchase cancellations by prospective home buyers. The U.S. economy, dragged down by housing, grew at a 1.6 percent annual pace last quarter. 

     The housing market is seeing ``significant price softness'' and may be weaker than it appears, and the level of concessions by home builders to buyers is also a concern, Poole told the audience.

As reported by Bloomberg News

A paper published earlier this year in the Brookings Papers on Economic Activity (Aaronson et al., 2006) contains a summary table reporting four different projections of labor force growth out to 2014 based on the authors’ model and estimates from the Congressional Budget Office, the Bureau of Labor Statistics and the Social Security Administration. For 2007, the projections range from a low of 0.6 percent growth to a high of 1.1 percent growth. For 2014, the projections range from a low of 0.2 percent to a high of 0.8 percent.

The magnitude of these differences is stunning. Based on these projections, if the unemployment rate remains about steady next year we can expect average monthly growth of employment ranging from a low of about 70,000 to a high of about 120,000. These are rough, rounded off estimates—to provide the estimates any other way would imply a false sense of precision. On the same basis, in 2014, the range is from about 30,000 to about 100,000 new jobs each month. These are very large differences. Moreover, given that each of the models used to produce these estimates is subject to error, in fact the range of uncertainty is even greater than the numbers just quoted.

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

Federal Reserve Bank of St. Louis President William Poole said the central bank's interest-rate stance is ``about right,'' though higher borrowing costs will be needed should the Fed fail to bring inflation down.
     ``We need a policy that is disciplined enough to get the job done, but not more so,'' Poole told reporters after a speech in Wilmington, Delaware. ``If all the information taken together suggests that we are not making progress, then I will be among those who will push for a tighter policy.''

...He reiterated that he sees the outlook for the fed funds rate as ``roughly symmetrical,'' meaning the chances of an interest-rate cut and an increase are about equal. He didn't give a time frame for the next move up or down.

Finally, Congress should create a prompt corrective action (PCA) policy regime for the GSEs that truly mimics the one that was introduced into U.S. banking law 15 years ago. The idea behind PCA is simple—if a regulated firm holds only a small buffer of capital to protect the firm’s debt holders from loss, it is critically important that the firm face immediate and increasingly stringent restrictions on its activities as its capital dwindles. Otherwise, an undercapitalized firm experiences even stronger incentives to exploit its unpriced real or perceived guarantees.

...The PCA regime has a major advantage for regulators in that they are instructed by law not to engage in regulatory forbearance, the source of some of the problems that eventually led to the collapse of numerous savings institutions in the 1980s and early 1990s. The only way to deal with time inconsistency is to make bailouts unlikely by tying the hands of regulators. Taking away the power to provide a bailout permits regulators to put more pressure on firms earlier. Moreover, in the absence of regulatory discretion, firms know that a bailout requires a successful approach directly to Congress, which might or might not be successful. Uncertainty over congressional action adds to market discipline.

A very interesting case arose with the terrorist attacks on 9/11. Thinking back to my academic years before coming to St. Louis, I recall no discussion or journal articles analyzing the possibility that the payments system might crash because of physical destruction. But that is what nearly happened, because the Bank of New York, a major clearing bank, was disabled when the twin towers came down. Moreover, trading closed in the U.S. Treasury and equity markets, and banks were unable to transfer funds because the Bank of New York was not functioning. With normal sources of liquidity shut down, many banks faced the prospect of being unable to meet their obligations. The Fed’s provision of funds through the discount window and in other ways prevented a cascading of defaults around the world. No private entity would have been able to provide liquidity on such a massive scale.

...I believe the markets do have confidence that the Fed has necessary legal authority and the internal strength to act as necessary. That said, the Fed’s reluctance to act is also an important element of strength.

Some observers have viewed the large expansion of hedge funds as a rising danger to financial stability, requiring additional regulation and Fed readiness to intervene. I myself believe the dangers of systemic problems from hedge fund failures are vastly overrated. The hedge fund industry is indeed large but it is also highly diverse and competitive. Many and perhaps most of the large positions taken by individual firms have other hedge funds on the opposite side of the transactions. I trust normal market mechanisms to handle any problems that might arise.

I believe that supervisory oversight is in pretty good shape, with one glaring exception. Government-sponsored enterprises are not adequately capitalized and the supervisory powers of the Office of Federal Housing Enterprise Oversight (OHFEO) are inadequate. I’ll concentrate on the housing GSEs—Fannie Mae and Freddie Mac. This is a topic I’ve addressed several times in the past (Poole, 2003 and 2004) and I’ll not repeat those arguments in any detail here. Although the GSEs are not formally insured by the federal government, the market clearly believes that they are effectively backstopped.

As I’ve emphasized before, the Federal Reserve does not have the legal authority to bail out a troubled GSE. The Fed can provide liquidity support through its discount window, but only indirectly through collateralized loans to banks that would then bear the credit risk of making loans to a troubled firm.  Under emergency conditions, the Fed does have the authority to make loans directly to a GSE, but the loans must be fully collateralized. The Fed is obviously disinclined to use its emergency powers to lend to firms other than banks; despite numerous financial upsets over the years, the Fed has not used this authority since the 1930s.

The key issue ... is time inconsistency. It seems to make sense in the middle of a financial crisis for someone to bail out a failing firm or firms. However, the inconsistency is that, however sensible a bailout seems in the heat of crisis, bailouts rarely make sense as a standard element of policy. The reason is simple: Firms, expecting aid if they end up in trouble, hold too little capital and take too many risks. As every economist understands, a policy of bailing out failing firms will increase the number of financial crises and the number of bailouts. Along the way, the policy also encourages inefficient risk-management decisions by firms.

The general tenor of the data has suggested that inflation is leveling off or declining, rather than continuing to rise.

...The St. Louis Fed president said the cost of another round of inflation pressures "could be quite large", and in that regard he is "asymmetrical" in his assessment of the risks to the economy of a sustained period of elevated inflation. 

"However, my judgment is that looking ahead the risks the data will come in higher than anticipated on inflation are roughly symmetrical with the risk that the inflation issue will subside," Poole said.  The current level of the federal funds rate is "just about right given the information we have".

As reported by Bloomberg News

Eurodollar futures have an accuracy rate of less than 30 percent since 1994 in forecasting the target rate for overnight loans between banks six months later, the St. Louis Fed said in an August study...  ``Those are the best forecasts we have, but they're simply not very accurate at the end of the day,'' Poole said in an interview last week.

Poole said FOMC meetings have changed since Ben Bernanke took the helm at the Fed. Unlike the former chief, Alan Greenspan, Bernanke only comes out with his views toward the end of the meeting. It is also possible to make comments during the presentations of other colleagues. 

"That offers more time for discussion when thoughts are fresh," Poole said.

From a Dow Jones summary of a FAZ article

  "I'd prefer an inflation target of zero, assuming it was possible to exactly measure the rate of purchasing power erosion," Poole said in the interview.
  Since that isn't possible, the Fed should establish a core inflation target of 1%-2%, Poole said, according to the article.
  "A lot would be gained in terms of discussions at the Federal Reserve Open Market Committee," Poole said. "The discussion would be clearer because everybody would mean the same thing when they speak of price stability."
  The discussion on the Fed's communication policy, which could result in the adoption of an inflation target, will probably take some time, Poole added.

From a DJ summary of a FAZ interview.

I’ll confine most of my comments to Fannie Mae and Freddie Mac, where the largest issues arise. My purpose is to make the case once again that failure to reform these firms leaves in place a potential source of financial crisis. Although there is pending legislation in Congress, a major restructuring of these firms and genuine reform appear to be as distant as ever.

...

These two firms ...  cannot meet their growth targets in the long run if they confine their operations to conforming home mortgages. Their interest in increasing the conforming mortgage limit is clear. Moreover, in my opinion it is inevitable that they will look for ways to extend their operations into new areas. They have that clear incentive because of the implicit federal guarantee they enjoy. For them to extend their operations into market segments already well served by existing private firms will not enhance the efficiency of mortgage markets or reduce costs to mortgage borrowers.

I have never believed that slack is the main engine of inflation control.  I have talked about this a lot. If you take a standard Phillips Curve model, the inflation rate depends on a gap term, slack if you will, or resource utilization. {It also} depends on inflation expectations and a shock, or random term.  And I have often said that inflation expectations trump the gap.  So I put a high weight on inflation expectations. 

The view seems to be that someone, somehow, would do what is necessary in a crisis. Good risk management requires that the “someone” be identified and the “somehow” be specified. I have emphasized before that if you are thinking about the Federal Reserve as the “someone,” you should understand that the Fed can provide liquidity support but not capital.

It's always too early to give the "all-clear" on inflation risks. 

``We are well-positioned where we are,'' Poole said at a press conference in St. Louis. He reiterated his stance that he sees an equal chance the Fed could raise or lower interest rates.

"Only if the information were pretty compelling would I want to take the position of lowering rates," Poole said. "But I absolutely won't rule that out."

From audience Q&A as reported by Bloomberg News

Poole, who is on the voting panel of the Federal Reserve this year, again raised the prospect that the Fed's target rate could remain steady at 5.25% for some time to come, if growth remains on the expected path of 3%, and inflation continues to moderate.

"If that comes to pass," he said, the current target rate could be judged as "neutral." 

Nevertheless, Poole reiterated he would be ready to raise rates again to curb a rebound in inflation.   "I'm prepared to lean on the side of raising rates to make sure that inflation comes back convincingly in the 1-2% range [for core PCE].

As reported by Dow Jones News

The largest challenge facing the United States is not the business cycle but the task of adjusting on many fronts to the retirement of the baby boom generation. Fortunately, U.S. laws and institutions will enable us to face these challenges with a greater deal of optimism than in some other countries that will face the demographic challenge sooner and in larger measure than we will.

One of these risks, as I’ve noted earlier, is the possibility that we might be underestimating the likely pace of economic activity.  If we get an upside surprise on GDP growth, then monetary policy may have to be tightened somewhat.

If, however, core inflation seems to be settling at a rate above 2 percent, then such an outcome would be unacceptable to me. I put a very high weight on the Fed’s responsibility to maintain low and stable inflation...

My commitment, certainly, is to do what I can to promote policy adjustments that will yield an inflation outcome, on average over a period of several years, centered on 1½ percent on the core PCE price index. Such an outcome will ensure that the FOMC maintains its current high level of credibility. Maintaining price stability is central to maximizing sustainable economic growth and the highest possible level of employment.     

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

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

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

Statistically, there are several ways to estimate the normal level of starts. A common method is to estimate a model of some sort. For our purposes, assume that single-family housing starts in any year is a function of three primary variables: interest rates, household income and demographics.(2) In 2006, a model of this sort projected that housing starts would total about 1.7 million units, about 12.5 percent more than the actual level of about 1.5 million units. Assume: 1) no change in the average level of interest rates this year (relative to 2006); 2) that real GDP increases by 3 percent this year; and 3) that the number of households increases by 1 percent. With these assumptions, the model predicts that single-family housing starts will total about 1.4 million units this year, which we can compare to the actual 1.5 million units in 2006. This projection for 2007, which would be a 2.5 percent decline from 2006’s average, appears to be at the high-end of most forecasters’ expectation, perhaps because the model just outlined makes no allowance for the overhang of excessive inventory at the beginning of this year. But, eventually, as the inventory is worked off, home-building activity should pick up substantially from the 2006 year-end level of about 1.2 million units at an annual rate.

In response, builders naturally began to reduce new construction. Part of this pullback was motivated by skittish households; cancellation rates, according to some large builders, reached 40 percent or more during the latter part of 2006. Although the majority of forecasters correctly anticipated softness in housing construction, the magnitude of the decline exceeded their expectations...

A special word of caution is in order concerning housing data... To an unusual degree, sales data are affected by cancellations, which occur when buyers walk away from sales contracts. In published data, cancelled sales are not subtracted from new sales to create a net sales series. Moreover, cancelled sales are not put back into the data on the inventory of unsold new homes. Anecdotal reports clearly indicate that cancellations have been material. Thus, official data overstate net sales of new homes and understate the inventory of unsold homes. Finally, favorable recent news on the inventory of existing homes for sale may well have been influenced by discouraged homeowners taking their properties off the market rather than by actual sales.

The rise in productivity growth has increased the economy’s potential output growth. At present, many economists estimate the potential growth rate at between 3 and 3.5 percent.

The economy has performed well despite a near tripling of crude oil prices since December 2001. In years past, an energy price shock of this magnitude was typically associated with a substantial increase in inflation and a sharp recession.

Two things are different about energy price increases this time. One is that the increases were primarily a consequence of a booming world economy, which raised energy demand rather than a supply shock. Second, monetary policies here and in most other countries have done a fine job of anchoring inflation expectations.

By some indicators, the housing market is beginning to show signs of stabilizing. New single-family home sales rose in December, the fourth increase in the past five months, while in January the National Association of Home Builders’ housing market index—a measure of builder confidence—rose to its highest level since July 2006. Further, the four-week moving average of the Mortgage Bankers Association index of applications for home purchases has increased nicely since its trough last October. Finally, the University of Michigan’s consumer survey of home-buying conditions in January 2007 reportedly rose to its highest level since mid-2005.

The market for previously sold single-family homes may also have stabilized. Existing home sales rose a modest 0.1 percent in the fourth quarter of 2006, after declining 6.4 percent in the third quarter. Moreover, the pending home sales index reported by the National Association of Realtors turned up in January, registering its largest monthly increase since March 2004. Although the inventory of existing homes for sale, relative to sales, has also dropped over the past few months, its December level of 6.5 was still a bit above that for new homes, which stood at 5.9.

While recent data seem to point in a favorable direction, we must recognize that the housing market is not out of the woods yet. The most pressing issue for builders remains the backlog of unsold homes, at which they are chipping away, and the continued high rates of canceled orders.

[B]usiness fixed investment posted a slight decline in the fourth quarter. I suspect that the decline was nothing more than normal variation, perhaps a consequence in part of firms waiting for release of the new Vista operating system from Microsoft.

First, household saving behavior does not seem to have changed in any fundamental way. What has changed to a degree is the trend in asset values. Households have consumed some of the increase in asset values in about the same way they always have.

My second tentative conclusion is that the behavior of households, though perfectly sensible and responsible for households as a whole, has led to a situation in which the United States as a whole is saving too little of its national output. U.S. domestic investment has not suffered, because capital has been flowing into the United States from abroad. However, at some point the U.S. net international investment position will stop becoming ever more negative. U.S. saving will then finance a larger fraction of U.S. domestic investment and, perhaps, repurchase some U.S. assets now held by international investors. There is no reason why this adjustment should be difficult or disorderly, but it will require that U.S. consumption outlays expand more slowly than U.S. GDP for a time. 

"The economy is very evenly balanced. I think that a standard forecast for GDP is around 3 percent growth with inflation rate gradually tilting down," Poole said in an interview with Bloomberg Television. 

"As long as that situation prevails, the current interest rate environment, as far as I'm concerned, can stay right where it is," he added. 

As reported by Reuters

If we get surprises -- because we are running on the high side of anyone's inflation objective -- that suggest inflation is not likely to be on a downward trend, then I think what I would advocate is that we ought to be ready to raise rates.

[M]onetary policymakers often pay attention to “core” measures of prices that exclude energy and food prices. This focus does not, however, mean that policymakers’ concept of price stability refers only to a basket of goods that excludes energy-intensive items. The overall cost of living is what matters for welfare, so stability over time in indexes that include energy is desirable. But because the price of gasoline is volatile, it is often desirable to “see through” very short-term movements in consumer prices, and work out what is happening to the underlying trend of prices. Looking at core measures of inflation can be useful for this purpose. Indeed core and aggregate inflation clearly move together over longer periods. That said, during periods of sustained increases in relative energy prices, general price stability requires that price indexes that exclude energy will need to grow more slowly than the aggregate price index; over this period, achievement of inflation at a desirable level means that core inflation, on average, proceeds below the overall level of inflation.

In recent years, ... the circumstances of the 1973 oil shock have not been repeated. The economy has not been overheated; the economy is more energy-efficient so the impact on supply of oil shocks has been moderated; and the more severe spikes in the oil price such as in summer 2006 have been recognized as transitory in nature. In these circumstances, monetary policy is in a much better position to support aggregate demand in the face of oil shocks without endangering medium-term price stability. This state of affairs has been emphasized by the Federal Reserve Chairman in his discussion of the effect of oil shocks. 

But at this point, it seems to me there is no, my judgment, no pressing need for any immediate action {in response to the drop in the stock market}. There is a lot of stability in the market responses themselves. Just for example, should it turn out, this is not a forecast by any means, but should it turn out that the economy is weaker than the prevailing baseline forecasts that I talked about, then you'll see interest rates in general declining in anticipation of future Federal Reserve action, and that will help to stabilize the economy and prevent the weakness from developing into a serious matter.

In comments to reporters after his speech, as reported by Bloomberg News

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

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

     "At the present time, stock market valuation doesn't seem to be elevated, certainly not as it was at the end of 2000. And the latest information on manufacturing, the ISM report, was apparently quite strong.''

     ``We don't see the accumulating evidence that would justify ongoing market declines. Should that happen -- I'm not trying to predict that the stock market will go one way or another because I know that's a very dangerous thing to do -- should the market decline without any underlying supporting evidence to justify the declines, then I would say my own view would certainly be that it's a fluctuation in the market of the type that occur that are very difficult to understand or explain.''

     In ``the absence of other information there would be no particular reason for the FOMC to respond to the stock market itself.''

In comments to reporters after his speech, as reported by Bloomberg News

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

I believe that the optimal rate of inflation is zero, properly measured. However, biases in price indexes imply that, in practice, price stability will likely be consistent with a small positive measured rate of inflation. These biases arise from the difficulty of capturing improvements in the quality of goods and services, as well as substitutions among products that comprise consumers’ total purchases. Differences in how price indexes are put together imply that the specific rate of inflation that is consistent with price stability will likely vary across countries and over time. For the United States, I’ll hazard a guess that zero true inflation translates to an annual rate of increase in the CPI of about 1 percent and in the broader price index for personal consumption expenditures of about 0.5 percent.

...

A number of FOMC members have spoken about a “comfort zone” of 1 to 2 percent inflation, measured by the PCE price index excluding food and energy—the so-called “core” inflation rate.  That statement is fully acceptable to me.  My way of stating my comfort zone is core inflation of 1.5 percent per year, plus or minus a range of 0.5 percent to allow for unavoidable short-run fluctuations.  My statement is meant to indicate that I would like monetary policy to aim at 1.5 percent core inflation and not just accept inflation barely inside one end or the other of a 1 to 2 percent range.  

In the 1960s, political pressure for low interest rates combined forces with a growing consensus among economists and policymakers that moderate inflation is an acceptable way to boost employment and economic growth. Monetary policymaking was viewed as simply a matter of selecting from among a menu of inflation and unemployment options. Choose a little more inflation and unemployment would fall, according to this theory. Accept somewhat higher unemployment, on the other hand, and inflation would be a bit lower.

The infamous Phillips curve made policymaking seem beguilingly simple. Based on this theory, several influential economists argued that the menu of inflation-unemployment options offered by the Phillips curve could be improved upon if policymakers were willing to discard their old-fashioned attraction to price stability. Forego price stability, these economists argued, and the labor market would operate more efficiently, employment would rise and the economy would grow faster.

To me, and I believe the mainstream forecasters both in government and out - we don't see a recession on the horizon," Poole said after a speech in Santiago. Moreover, "the market itself, to me, is not showing evidence that estimates of recession are really in the cards."

The fact that you had very well informed people coming to different conclusions about what the statement meant -- that, in and of itself, is evidence that the statement was not completely successful.   If it were completely clear, well informed people would come to the same conclusion from the same words.

It is very difficult to craft these statements so that well informed people all come to the same conclusion.  Chairman Greenspan often wrote with the expectation that people would read between the lines. I think Chairman Bernanke is trying very hard to have people read the lines and not draw implications from reading between the lines when no implication was meant to be there.

From Q&A session, as reported by Bloomberg News

There would have to be a high hurdle for me to want to be cutting rates if the economy is only marginally and tentatively on the weak side' and inflation isn't slowing toward 2 percent.

From the audience Q&A session, as reported by Bloomberg News

I regard “price stability” as zero inflation, properly measured. What does “properly measured” mean? Price indexes have biases of various sorts and experts generally believe that U.S. indexes overstate inflation by a modest amount. If statisticians understood these biases with precision, the indexes could be corrected. I myself make a rough guess that, for example, the Consumer Price Index overstates inflation by about one percentage point a year.

...In recent years several FOMC members have referred to a “comfort zone” of 1-2 percent inflation measured by the price index for personal consumption expenditures, excluding the volatile food and energy components. Because agreement on some reasonably low rate of inflation is more important than exactly what that rate is, I am perfectly happy to state my personal inflation objective as an inflation rate measured by the core PCE price index of 1.5 percent, plus or minus 0.5 percent.

As always, my view on economic growth and inflation emphasizes longer-run conditions. I could point to numerous past episodes of either faster or slower growth for a few quarters that we now ignore because long-run developments dominated the outcome and indeed dominate our current assessment of these periods. In assessing short-run developments, it is also essential to keep in mind that forecasts have standard errors. Over a four-quarter horizon, a GDP forecast has a standard error of about 1.5 percentage points and an inflation forecast has a standard error of about 0.5 percentage points. We know also that data are often revised. Finally, monetary policy cannot affect near-term conditions anyway. Thus, a focus on medium- and long-term fundamentals is always appropriate.

[Poole] expressed relatively little concern about the probability of recession on the heels of Greenspan's prediction of a 1 in 3 chance of recession before year's end. Poole noted that recession probability models always show a 10%-15% chance of recession even during what are viewed in retrospect as solid business cycles.

However, he did say that the chances of recession are "slightly elevated." "My own take is that it's somewhere between that [Greenspan's prediction] and normal [10-15%]," he said.

From Q&A session, as reported by Market News

In answering audience questions earlier, Poole spoke about how observers can judge whether or not the Fed will intervene in economic crises. "The goal ought to be to be able to write something [rules for intervention] down in a formal fashion," Poole said. "We're not there yet but I'll tell you there's much more predictability than you might realize and ... there are events that can happen where you won't have any doubt as to how the fed is going to respond." He cited the failure of Long Term Capital Management and 9/11 as an examples where uncertainty was rampant and spreads "moved to a surprisingly large extent."

As reported by Market News

Money growth doesn't feed quickly into inflation, Poole said.  He also commented that in his opinion sweep accounts had made the M1 measure "useless."

From Q&A session, as reported by Market News

However inflation is measured, economists agree that monetary policy has at most a minimal influence on the rate of change in the price level over relatively short time periods—months, quarters or perhaps even a year. Central banks are responsible for medium- and long-term inflation—such inflation, as Milton Friedman wrote, is a monetary phenomenon that depends on past, current and expected future monetary policy. As a practical matter, the medium- to long-term likely is a period of two to five years.

It used to be thought that the dual mandate required the Fed to temper pursuit of its inflation goal from time to time in the interest of minimizing disturbances to employment. That view began to change 40 years ago. Over time, the mainstream view in the economics profession has increasingly emphasized the importance of price stability for achieving maximum employment and maximum sustainable economic growth. I myself have become passionate about price stability. It is important to remember that the two greatest employment disasters in U.S. history were the Great Depression and the Great Inflation. Deflation from late 1929 to 1933 drove the U.S. economy down and down, and the unemployment rate rose to 25 percent. During the Great Inflation, from 1965 to 1981, the United States suffered four recessions, the last of which in 1981-82 drove the unemployment rate to a peak of 10.7 percent at the end of 1982, the highest since the Great Depression.

Experience abroad confirms the connection between price instability and unemployment. For one example, Japan suffered a decade of deflation in the 1990s; economic growth was minimal and unemployment rose.

I especially want to highlight my unease with using the term “imbalances” to characterize the current situation. That term almost begs for a policy response—how can policymakers allow imbalances to persist? Unfortunately, policy responses could well involve damaging protectionist measures. I will argue that, to a large extent, the current situation is not fundamentally an imbalance but rather a condition that is conducive to coping with the major demographic changes that are occurring throughout the world.

When a population can be characterized as middle aged, then the economy should tend to have a higher saving rate than when it can be characterized as elderly. Thus, as the population of a country moves from middle aged to elderly, it is reasonable to expect a country’s saving rate to decrease. Unless the country’s investment rate moves identically, foreign capital flows and current account balances will be affected. Exactly how depends on the change in investment.

I believe the fundamental problems in the non-prime mortgage market amenable to improvement stem from inadequate incentives among some of the parties operating in the market to create and maintain strong reputations for quality and fair-dealing.   

It is important to emphasize that what is odd is not that there was a risk of rising short-term interest rates, as there always is, but that the market clearly expected an increase, as indicated by the shape of the yield curve. This expectation, in turn, was encouraged by the Fed’s Open Market Committee. The policy statement issued at the conclusion of the FOMC meeting of May 4, 2004, said that “the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.” A similar phrase appeared in subsequent FOMC policy statements until December 2005, when the language was changed slightly to “the Committee judges that some further measured policy firming is likely to be needed.” At its next meeting, in January 2006, the language changed from “is likely to be needed” to “may be needed,” and somewhat similar language remained in the policy statement through the FOMC meeting in January 2007.

Given these widely held expectations of rising interest rates, it is difficult to avoid the judgment that these ARM loans were poorly underwritten at the outset. It was imprudent for mortgage brokers and lenders to approve borrowers who likely could not service the loans when rates rose, and it is surprising to me that sophisticated capital-market investors willingly purchased securities backed by such poorly underwritten mortgages.

World energy demands are likely to continue to grow rapidly, as economic growth in China and India has developed substantial momentum. We should hope that growth will take hold in Africa and in Middle Eastern countries. If it does, rapid economic development in those areas will add further to growth in world energy demand.  Whether higher growth in the world economy will continue to push energy prices up will depend on developments in energy supply. There are many promising technologies that in time could make important contributions to energy supplies.

Over the past four years, we have seen none of the macroeconomic complications of the early energy price shocks. An important part of the difference this time is that the recent trend in relative energy prices has been driven by rapidly increasing world demand for energy.  Figure 7 shows energy consumption in four major economic areas: the United States, Europe, Japan and China plus India.(1) The latest data available are for 2004. Between 2002 and 2004, primary world energy consumption increased 9 percent...

However, energy markets work! The real price increases have provoked a response in production sufficient to accommodate the higher demand. World production of primary energy increased 9.1 percent from 2002 through 2004. The price mechanism in world energy markets is alive and functioning well to increase total production and to allocate available supply among the existing and emerging sources of demand.

It is highly desirable that the central bank behave in a rule-like way, both for the political objective of the rule of law rather than the rule of men and because predictable policy promotes more efficient decisions in the private sector. To the maximum possible extent, we desire an equilibrium in which the markets behave as the central bank expects and the central bank behaves as the markets expect. Central bank behavior to anchor expectations of low and stable inflation is the single most important aspect of policy predictability. I believe that the Fed has come a long way in that direction though, obviously, there are certainly opportunities for the Fed to refine its policy rule. In this context, by “rule” I simply mean that the Fed’s policy actions are systematic and highly predictable responses to new information.

Consider where this analysis leaves us...  The central bank can hold its policy rate relatively steady and rely on market adjustments in long rates to do much of the stabilization work... The current situation is a perfect illustration. The Fed doesn’t know and market participants do not know either, the full implications of last week’s stock market declines and increases in risk spreads. Market reactions last week may be overdone, or perhaps not. We just do not know. In a situation like the terrorist attacks of 9/11, the Fed knew enough to believe that a quick policy response would be helpful and unlikely to itself be destabilizing.

A typical market upset, such as last week’s, is not at all like 9/11. Most of these upsets stabilize on their own, but some do not. I’m not saying that the Fed should ignore what happened last week—we need to understand what is happening. However, it is important that the Fed not permit uncertainty over policy to add to the existing uncertainty. The market understands, I believe, that the Fed will act in due time, if and when evidence accumulates that action would be appropriate. That is why trading in the federal funds futures market reflects changed odds from two weeks ago on a policy adjustment later this year...

The regularity of Fed behavior I espouse is that the Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment, or when financial-market developments threaten market processes themselves... [E]ffects on the economy can rarely be understood without passage of time and more information. Occasionally, there is contemporaneous evidence of damage to market mechanisms that might justify quick Fed action.

As a card-carrying monetarist, I argued the steady money growth case vigorously in years past, and it is still my conviction that a central bank ignores money growth at its peril...

Everything Milton argued about money stock control is true, but the effect of inflation expectations on the practice of monetary policy itself was, I believe, a missing element in the analysis...

...I believe that the Fed’s actual adjustments of its federal funds rate target have yielded superior outcomes since 1982 to what we would have observed under steady money growth. I also believe that advances in knowledge permit us to say with some confidence that these gains are not just an accident of Alan Greenspan’s special skills and intuition.

    William Poole, president of the Federal Reserve Bank of St. Louis, said there's no sign that the subprime-mortgage rout is harming the broader U.S. economy, and an interest-rate cut isn't yet needed.   ``I don't see any impact as yet on the real economy or on the inflation rate,'' he said in an interview in the bank's boardroom. ``Obviously, there could be an impact, but we have to rely on some real evidence.''
     Barring a ``calamity,'' there is no need to consider an emergency rate cut, Poole said. His comments were the first by a Fed official since the U.S. central bank joined counterparts in
Europe and Asia to inject emergency funds after a surge in money-market rates. The Fed has added $71 billion of reserves in the past five trading days.
     Poole, 70, said businesses have maintained their hiring and investment plans and banks have sufficient capital to weather the credit-market turmoil. The St. Louis Fed chief stressed that the best course is for policy makers to assess the latest economic data when they next meet Sept. 18. The comments contrast with the certainty that traders put on a rate cut next month.   ``If the data confirm the market's view that the economy is sagging, we'll have to decide whether to share that view,'' said Poole, who votes on the rate-setting Federal Open MarketCommittee this year. He cited the monthly jobs, retail sales and industrial production reports as key gauges he'll be watching.

As reported by Bloomberg News

U.S. exporters are formidable competitors in international markets and can become even more formidable competitors in an international trading environment as free as possible of governmentally imposed barriers.  The increasing involvement in markets globally serves the best interests of U.S. residents, both as consumers and as workers.  In terms of income, the payoffs from prior liberalizations of trade and investment flows have been quite large.  I am certain that actions hindering entry of U.S. innovators and entrepreneurs in global markets will ultimately prove harmful to economic well-being in Arkansas and the United States generally.  Thus, we should all be concerned about the current lack of progress in liberalizing trade flows and the increasing threat of legislation tending toward economic isolation.  Such actions, if they occur, will depress exports in the future from Arkansas and the United States as a whole.  More importantly, governmental actions that depress exports will ultimately harm U.S. income prospects by inhibiting productivity and income growth.     

Growth in U.S. exports in coming years will play a critical role in creating better jobs. U.S. exporting firms on average enjoy higher productivity than those that sell only into the U.S. internal market. Because export opportunities are especially great to countries abroad that are growing rapidly, we need to encourage that growth, or at least not interfere with it. Imports into the United States from high-growth countries help to encourage growth abroad. We have a common interest with all the countries of the world in promoting trade liberalization. Increasing liberalization is central to creating better jobs around the world, including here at home. In our approaches to trade issues, we need to shift attention from protecting workers against imports to protecting exports. That will be the key to a more prosperous future.

Within recent years, a significant anti-trade sentiment seems to have emerged in the developed world.  As policymakers, it is incumbent upon us to maintain a commitment to free and open trade, while helping those who experience losses from it find new opportunities.  In doing so, we hope to ensure continued increases in our standard of living and persuade greater numbers of people that trade can be beneficial for everyone. 

We have tentative signs that the financial markets are beginning to recover from the recent upset, but financial fragility is obviously still an issue.  If the upset were to deepen in a sustained way, it might have serious consequences for employment stability.  As of today, we just do not know what the consequences may be.  My best guess is that the inherent resilience of the U.S. economy along with future policy actions, should they be desirable, will keep the economy on a track of moderate average growth and gradually declining inflation over the next few years.    

An important corollary to the task of defining a policy rule is that the central bank ought not to be a source of random disturbances. All of us are well aware of the potential for saying things inadvertently that will create market misunderstanding of likely Fed future policy actions. ... One way to avoid misinformation is to avoid providing any information. Put another way, if my mouth is not open, I cannot put my foot into it.

In my view, however, it is important to try to convey correct information. I do not believe that I would be doing my job if fear of providing misinformation led me to provide no information. For this reason, I have maintained an active speaking schedule.

I personally believe, and have so stated on numerous occasions, that the inflation goal should be quantified. I know that many disagree on this point. In today’s economy, I believe that a quantified inflation goal is not critically important but quantification might be of great importance in the future.

Turning to the Fed's hefty 50-basis-point cut in the federal-funds rate, Poole said that the market was bound to be surprised, pointing to what the fed-funds futures market was showing at the time.    "There was was going to be a surprise...no matter the way we did it," he said. "The only way to meet market expectations would have been a 14-basis-point cut."

From the Q&A as reported by Dow Jones News

Fed policymakers, on the other hand, do not continuously adjust the stance of policy in the same way managers adjust portfolio holdings. For this reason, my own practice is not to worry much as to whether I have correctly absorbed the import of each day’s, or each hour’s, data. I know that some information will be irrelevant to my policy position because it will be by new information by the time of the next FOMC meeting... Given that the FOMC does not adjust policy continuously, updating my forecast with every data release would not be an efficient use of my time.

A consequence of the fact that FOMC meetings occur at six-week intervals, on average, is that when I give a speech and take questions I may not be completely up to date on the implications of the latest data. In my speeches and discussions of policy with various audiences, I try to concentrate on longer-run issues and general principles. I emphasize that I will be studying all the data and anecdotal information in the days leading up to an FOMC meeting. Thus, I ordinarily do not give detailed answers to questions on the precise implications of the latest data for the economic outlook. In many cases, I just haven’t studied the implications thoroughly, although I certainly do so by the time the FOMC next meets.

Econometric models can estimate approximate effects on the overall economy from changes in real estate activity. Still, economists know that our knowledge is incomplete. It is no secret that the downturn in residential real estate activity is more severe than most forecasters expected only a few months ago.

The financial market turmoil that began in August hit hard an already struggling housing market. Financial markets appear to be stabilizing, but they have not returned to normal and are still fragile. Most forecasters have reduced their expectations for GDP growth and believe that downside risks have risen. However, the employment report for September, the latest available at this time, does not suggest that the downside risk is occurring. As an aside, the substantial upward revisions to data released in the August report remind us that it is a mistake to place too much weight on any one report.

The Federal Reserve has neither the power nor the desire to bail out bad investments. We do have the responsibility to do what we can to maintain normal financial market processes. What that means, in my view, is that we want to see restoration of active trading in assets of all sorts and in all risk classes. It is for the market to judge whether securities backed by subprime mortgages are worth 20 cents on the dollar, or 50 cents, or 100 cents. Obviously, the market will judge different subprime assets differently, based on careful analysis of the underlying mortgages. That process will take time, as it is expensive to conduct the analysis that good mortgage underwriting would have conducted in the first place. Although there is a substantial distance to go, restoration of normal spreads and trading activity appears to be under way, and we can be confident that in time the market will straighten out the problems. We do not know, however, how much time will be required for us to be able to say that the current episode is over.

One of the most significant changes in the U.S. economy over the past quarter century has been the marked reduction in economic volatility. Following the terminology of the Great Depression and the Great Inflation, this period of increased stability has been termed “The Great Moderation.”

The Great Moderation—this period of relatively stable GDP growth—has been accompanied by a lower average level and reduced volatility of long-term interest rates. The more stable financial environment makes it easier for firms and households to plan for the future. The Great Moderation has also made the job of forecasters somewhat easier.

Current difficulties afflicting the real estate sector have, to date, been confined to the residential sector; business outlays for structures have been quite strong. Since its peak in 2005:Q4, real residential fixed investment expenditures have declined by 19 percent. Over the same interval, real business investment in structures has increased by 21 percent. If you plot these two series on a chart, they would look like scissors: one line going up and one line going down—and their slopes would be quite steep. Indeed their slopes suggest that the current rates of change are not sustainable. Housing will not continue to fall at double-digit rates, and outlays for business structures will not continue to increase at double-digit rates.

Unfortunately, recent events suggest that housing will remain weak for several more quarters; stabilization may not begin until well into 2008. Probably the most important statistics in this regard are the number of unsold new homes still on the market relative to their current sales rate and the recent trends in house prices.

Although this episode of financial turmoil is still unfolding, my preliminary judgment is that there are no new lessons. Weak underwriting practices put far too many borrowers into unsuitable mortgages. As borrowers default, they suffer the consequences of foreclosure and loss of whatever equity they had in their homes. It is painful to have to move, especially under such forced circumstances. Investors are suffering heavy losses. There is no new lesson here: Sound mortgage underwriting should always be based on analysis of the borrower’s capacity to repay and not on the assumption that a bad loan can be recovered through foreclosure without loss because of rising property values.

The other aspect of the current financial turmoil that reaffirms an old lesson is that it is risky to finance long-term assets with short-term liabilities.

I think we have to be ready for surprising developments in either direction. We have to be prepared to be nimble in either direction. Because it could be that all sorts of things would shake out relatively easily and comfortably and it could be that they won’t. I just don’t know.

In an interview with the Wall Street Journal

William Poole, president of the Federal Reserve Bank of St. Louis, says credit markets show “evidence of a healing process underway” but one that is still “very incomplete.”

....

The investment fund being organized by top U.S. banks — the so-called super-SIV to prop up the mortgage-securities market — is “an effort to promote some better price discovery of what those assets are really worth,” Mr. Poole said. “I don’t know enough about it and I don’t know whether it’s actually going to work or not. … But it’s the kind of device that you would expect the markets to create — some devices to start moving toward normal.”

In an interview with the Wall Street Journal

At issue is the potential effect of the housing decline on consumer expenditures. The loss of wealth associated with the decline in housing prices, as well as the fact that mortgage payments will absorb a larger portion of disposable income for some consumers, might cause consumption—the largest component of GDP—to grow at a significantly slower rate. While the effect of a change in wealth on consumer expenditures has been notoriously difficult to identify empirically, some recent evidence suggests that changes in housing wealth do affect consumption. 

When the Fed cuts its target for the federal funds rate, market participants know that the FOMCs decision at its next meeting will be either to leave the rate unchanged or to cut further. Barring unusual circumstances, the FOMC would not consider a rate increase just after cutting its fed funds rate target. This approach to policy is appropriate when market conditions are fragile because market participants must be confident that they can take positions without the risk that the Fed might raise rates, which would reduce asset values, in the near term.

As markets return to normal, Fed policy can also return to its normal focus on the long-run needs of the economy. ... As markets heal, the policy situation may return to one resembling that of a few months ago in June, before subprime problems began to have significant market impact. Although I am unable to forecast the future course of the FOMCs target for the federal funds rate, I am confident that normal market functioning will return to the financial markets. Recent weeks show clear progress.

What creates generalized financial turmoil out of a market problem is that investors flee riskier assets of all types, with little regard to whether the assets are connected to the original problem or not. However, a flight to quality typically does not last very long. Investors start to make the relevant distinctions as they search for good assets trading at distressed prices. That process is certainly observable today.

[I]f the fourth quarter comes in exactly as anticipated, and given that there's already been 75 basis points of easing, and given that we can't affect the fourth quarter anyway - the fourth quarter is going to be irrelevant to the December decision unless it tells us something about next year we don't already know.

"You need to take this next evolution in the communication strategy pretty much on its terms," Poole said. "What's appropriate to read into it you and I won't know until we have some experience with it," and that could take years.   

Poole cautioned observers that under the new strategy, "there needs to be a lot attention paid not so much to the forecast itself but how it has changed from the previous forecast, and what are the events that led to that change."  Because future economic events are so frequently surprising, what's more important is that observers use the forecasts to divine the pattern by which central bankers react to data. 

"We can't tell you what we are going to do because we can't predict the information that is going to determine what we are going to do," Poole said.  But, "over time these quarterly updates to the outlook will enable analysts to connect the change in the outlook to the change in the policy stance," Poole explained.

As reported by Dow Jones News

Poole noted while policy makers are clearly mindful of what markets expect, "if all the Fed does is follow the market, there can only be chaos. The Fed must lead this process."

As reported by Dow Jones News

Some have argued, Hyman Minsky most prominently,(8) that monetary policy success breeds greater financial instability by encouraging investors to assume more risk, especially through greater leverage. Perhaps this contention is at the heart of the argument that recent Fed policy actions in response to the subprime mortgage mess will only increase financial risks in the future.

It is hard to figure out how to test the Minsky proposition, but my instinct is that it is not correct. As vexing as the current market situation is, it is important to remember that in the early 1980s the unwinding of the Great Inflation led to failure of many industrial firms, farmers, banks and eventually a large part of the savings and loan industry. The financial turmoil of 1998 seems mild by comparison with the early 1980s; of course, we do not yet know the full extent of the current turmoil in housing and housing finance.

There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.

When such a shock occurs, market participants may be unsure about the appropriate response, and the central bank may also be unsure. Nevertheless, market participants have good reason to believe that the central bank will respond as the appropriate response becomes clear. Confidence in the central bank in this sense helps to stabilize markets.

Clearly, recent Fed policy actions have not protected investors in subprime paper. The policy objective is not to prevent losses but to restore normal market processes. The issue is not whether subprime paper will trade at 70 cents on the dollar, or 30 cents, but that the paper in fact can trade at some market price determined by usual market processes. Since August, such paper has traded hardly at all. An active financial market is central to the process of economic growth and it is that growth, not prices in financial markets per se, that the Fed cares about.   

The current financial turmoil will take awhile to play itself out. The fundamentals of our economy remain strong, however, and 2008 looks to be a year of rising growth. Economic forecasters expect slow expansion in the first half of the year and a quickening pace in the second half. Meanwhile, if borrowers, lenders and investors can refocus on financial basics and re-emphasize critical lessons about credit and risk, the financial future can be brighter than the second half of 2007. For that brighter future, we need to infuse our education at all levels with the lessons of 2007—old lessons to be sure but easy to understand at a very practical level from 2007 experience. With continuing effort we can expect that financial upsets such as the current one will be infrequent and milder when they do occur.  

Stable expectations allow us if we so choose to go slow with policy adjustments because when the evidence comes in we can catch up. Or, if we respond too much from a Monday morning quarterback standpoint, we don't create any lasting problem, because inflation expectations are entrenched and therefore the market doesn't run away with expectations.

From press Q&A, as reported by Market News International

"I'm not trying to put a gloss and say the economy is great," Poole said. "I'm trying to say the data to me are not clearly decisive on the downside" and "I would say the uncertainties are probably greater."  He added views about the outlook both within and without the Fed are "more diverse than typically the case."

...

The circumstances that we would see to justify a substantial policy easing would be the same as the people in the markets would see ... Having said that, keep in mind that interest rates have already come down quite a bit so given the lags in the process we would have to make a judgment about how much more would be appropriate given the new information.

From Q&A session as reported by Market News International and Dow Jones News

The St. Louis Fed President said when it comes to monetary policy changes, "ultimately, it's the chairman's call".

From the Q&A session as reported by Dow Jones

Let’s review the five major mistakes creating the subprime mess.

First, too many borrowers took on mortgages they could not afford...

Second..., mortgage brokers put too many borrowers into unsuitable mortgages...

Third, it is surprising to me that investment banks jeopardized their reputations by securitizing these mortgages when the underlying loans were backed by inadequate or spurious information.

Damaged reputations are also casualties of the fourth major mistake: rating agencies that placed AAA ratings on many securities backed by subprime mortgages...

The final entry on our major mistake list is investors who bought those securities without conducting an adequate analysis of the underlying investments.

It is interesting, and a bit depressing, that investment professionals made four of the five mistakes.

When I came to the St. Louis Fed, I was well prepared for my FOMC responsibilities in most respects. I knew a lot about monetary economics and monetary history. What I did not know was the art of communicating with the press and general public. The professional literature in economics was full of insights into the importance of private-sector expectations about monetary policy but essentially silent on how those expectations were formed, except for the assumption that expectations would not be systematically wrong and would converge to being correct eventually. Once I started fielding questions from the press after my speeches and talking informally before a wide range of audiences, I was part of the process of trying to establish correct expectations.

My general approach has been to speak primarily about the policy process rather than the specific situation facing the FOMC at its next meeting. I try to think of myself as speaking to portfolio managers who have a medium-term horizon rather than to traders who have a horizon measured in hours or a few days. I do not disparage traders—they perform an important function. Obviously, I have had internal information that would be of interest to traders but it would be entirely inappropriate—indeed illegal—to disclose confidential FOMC information.

Traders, portfolio managers and many others always want to know my forecast of what will happen at the upcoming FOMC meeting. My standard answer is that I do not forecast monetary policy decisions—my job is to participate in making those decisions. I confess that, initially, this response was something of a dodge, because I usually had a pretty good idea weeks in advance of what my own position at a meeting would be. However, over the years I have become impressed by how often my own position would change even in the days just before a meeting as a consequence of the arrival of new information, including staff analysis and sound arguments by my FOMC colleagues

As a consequence of observing this process for 10 years, I have concluded that an FOMC attempt to provide forward guidance in the policy statement causes more communications difficulties than it solves.  A key reason is that the economy is subject to more shocks and reversals than one might think. ... Directional language tends to remain in the FOMC policy statement beyond the time it applies and removing the language creates the possibility of miscommunication.  Every change in the policy statement leads naturally to market questions as to what the change means and whether the change is meant to provide a hint about the future direction of policy.  To my mind, every time new language is inserted into the policy statement, there needs to be as much thought given as to how to exit from the language as to the rationale for inserting it. 

Much of my thinking over the past 10 years has been devoted to this subject. What is the right policy? That is, how should individual policy actions be fit into a general policy and not be, or appear to be, drawn at random? I have given a number of speeches on this theme. We clearly have made progress in thinking about policy actions in this general way, although there is a long way to go to make the policy reaction function more precise both to guide policy actions themselves and to make those actions more predictable to the markets.

While identifying housing as still a key drag on the economy, he warned, "We must not allow our concern about 5% of the economy to screw up the other 95% of the economy." 

"Consumer debt, putting mortgages aside, is not likely to be a serious issue unless we have a serious rise in unemployment," he said.
"If we get a big decline in employment then there will be further shoes to drop."

From Q&A as reported by Market News International

The best bet is that we will not have a recession.  My take on the current policy situation is that policy is at a good place for both the long-run and for cushioning the impact of financial disturbances.
 ...
There is no question that the odds of a recession are higher than they used to be.

From Q&A, as reported by Bloomberg News and Market News International

Asked about whether it is true some financial institutions are too big to fail he said former Fed Chairman Alan Greenspan had it right when he said no institution is too big to fail, but the big ones can't be liquidated very quickly. In any event, it's the big bank shareholders
who would be wiped out and probably management too, not the customers of the bank which would be fixed so it could survive.

As reported by Market News International

The financial disruption is going to be handled in due time by the banks raising more capital and resuming the normal process of lending. That is taking place. I don't know how long it's going to take for it to be complete.

From audience Q&A, on the subprime mortgage crisis and related market turmoil. As reported by Market News International

The U.S. economy today is limping along. Some believe recession is at hand; others, and I include myself in this group, believe the economy will skirt recession. The difference in view may not be very large, as an economy growing at a barely positive rate will look and feel about the same as one with output falling slightly.

Could it be that there are now trends in place in the relative prices of food and energy? I am not prepared to dismiss this possibility. Rapid economic development in China and India has placed increased demand on the world capacity to produce both food and energy and therefore has surely contributed to the persistent gap between core and headline inflation numbers observed over the past five years. It is not unreasonable to forecast that increased demand for food and energy by emerging economies with large populations will continue for a considerable period. This possibility suggests the FOMC must exercise caution lest monetary policy inadvertently accommodate an increased inflation trend by focusing on the behavior of price indexes excluding food and energy.

You've got an industry here that's in depression ... But we have to be careful that we have monetary policy that is for the entire economy. We can't allow 5% of the economy to so dominate the monetary policy outcome that we forget about the other 95% of the economy.

From audience Q&A, when asked about the housing and residential construction downturn, as reported by Market News International

Recent research at the Federal Reserve Bank of St. Louis suggests that such movements along a short-run Phillips curve or transitory shifts up and down in that curve only account for a relatively minor portion of the observed inflation in the United States since the mid 1950s. The dominant factor in U.S. inflation history over the past 50 years has been changes in inflation expectations, or semi-permanent shifts up and down in the short-run Phillips curve. When it comes to the forces behind U.S. inflation, expectations trump the gap.(6) While some observers might be startled by this conclusion, reflection on the broad outline of our economic history should allay any apprehensions. In the 1960s and 1970s, successive business cycle peaks had both higher inflation and higher unemployment rates, explained by increases in inflation expectations. After the recession of 1990-91, both inflation and unemployment trended down for the remainder of the decade. In the textbook paradigm, such patterns can only be produced by shifts in the short-run Phillips curve generated by changes in inflation expectations. Indeed, direct evidence on inflation expectations suggests that expectations did trend gradually down over the 1990s.

The conclusion that expectations trump the gap in generating inflation is extremely important for monetary policy. It implies that low and stable inflation will only be observed when the private sector’s expectations of inflation are solidly entrenched at a low level.

In present circumstances, monetary policymakers will need to be careful to react to evidence on the state of the economy and likely outlook for employment. The issue is likely developments in the labor market and not merely possible developments. At the same time, policymakers will have to remain conscious of the lessons of history with regard to inflation. Here again, likely developments and not just possible developments must be the focus of attention. Risk mitigation to counter costly possible developments is an important strategy, but taking out insurance against certain risks is not free.

Although the danger is real, it is also true that oil futures prices for contracts several years ahead do not suggest continuing increases in oil prices of the magnitude observed over the past five years. That was also true five years ago—the futures market turned out to be wrong. However, my view is that policymakers should rely on the judgment of the markets unless we have solid evidence that the markets are wrong. My personal experience is that, although the markets obviously can be wrong, I have no confidence that my own judgment on something like oil prices will be systematically more accurate.

While the Federal Open Market Committee (FOMC)—the Federal Reserve’s main monetary policymaking body—has not adopted an explicit numeric inflation target, many individual FOMC participants have been quite forthright about their views on price stability or “comfort zones” for inflation. I am on record as favoring a target in terms of the personal consumption price index of 1.5 percent annual rate of increase plus or minus 0.5 percent.

Controlling Inflation
The issue today is less about the desirability of controlling inflation, or about the appropriate inflation target range, than about the specification of a monetary policy to achieve the agreed objectives of low inflation and a high level of employment.

HAYS:  Is the Fed pushing on a string now? Are these rate cuts going to work? Do you see a Fed that will keep cutting rates until it kind of forces some -- some buoying up of a system because we've seen instances, the 10-year note yield bottomed around January 22nd, it's higher since the big rate cuts in January. You, yourself said, a lot of people can't get mortgages. Again, Fed pushing on a string.

POOLE: The string analogy dates from the 1930's and one of the things that I said last week was that the Fed could follow a massively expansionary policy and essentially eliminate the possibility of a recession if that's what we wanted to do. I think it's much more pushing on a ramrod. It may not always seem that way, but I just don't think that this left-over analogy from the 1930's holds. I don't think it's based on good evidence.

"The markets are not healed, but I believe a lot of progress has been made," Poole said in an interview with Bloomberg Television. "You see a lot of the spreads narrowing, for example, the term Libor is more or less back to normal."

"A lot of banks and others are raising capital. We see the monoline insurance industry raising capital, getting things straightened out there. It's coming along."

As reported by Reuters.

As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues. I do not have any information on the GSEs that the market does not also have. Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.

U.S. banks entered the period of turmoil last year pretty well capitalized and have been able to withstand large losses.

I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector.

 In that situation, any intervention ought to take a form such that the costs to shareholders and management are so large that no firm in the future will want to allow itself to fall into such a situation. Lest I be regarded as a soft touch when I say that a situation could arise that could make intervention “inevitable,” I would set a very high bar to any intervention. Here is what I think is sound advice: “Experience suggests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a ‘clear and present danger.’” Some may be surprised to learn that the author of this sentence was Milton Friedman in his presidential address to the American Economic Association in 1967.

In any event, my view is that we should regard recent events in the mortgage market as reflecting the normal process of innovation. The lessons have been expensive and painful, and the pain is not yet over. As with the dot-com bust, where many firms went bankrupt but some sound business models survived, we should expect that successful innovations behind the subprime market will also survive. In time, I believe, we will find that the subprime sector of the mortgage market will be as normal as any other part of the mortgage market.

The public policy problem is the danger that, with the sad record of so many mistakes and abuses in recent years, regulatory burdens designed to end the abuses will do so but only at the cost of making subprime lending so costly and risky to lenders that they will have no interest in restoring this market. We should not forget that market discipline imposed by lenders who have suffered extremely large losses is already making it very difficult for anyone to originate subprime mortgages. In time, if new regulatory burdens do not become too great, we should expect to see new practices become standard.

Insurance against recession is not free. ... We have to have a balance (between) employment and financial risks with inflation risks

Neither Ned nor I, nor anybody else I think, started raising warning flags about large-scale defaults. Do I wish I had been there? Sure. Do I think it was dereliction of duty? No.

From reporter Q&A as reported by Market News International, when asked whether he regrets not seeing the subprime crisis coming. He said Gramlich warned about consumer protection, not broader financial instability.

I used to think of monetary policy as dealing with generally normal periods interrupted by shocks. I’ve decided that it’s really the other way around. In fact, the Fed has had to face a whole series of shocks interrupted by occasional periods that we call “normal.” If you were to take the 10 years as a whole and divide it between periods of shocks or the threat of shocks vs. the “normal” periods, I think you’d find a lot more months in the first category.

One of the biggest innovations came in 1994 when the FOMC began to disclose what its policy decision was after each meeting. The communication since then, however, has sometimes been a bit muddled. I don’t think there is a settled view in the FOMC about the value of essentially forecasting policy, or trying to give hints about where you’re going to go. I’ve become skeptical of that approach because I think the correlation between where you go and where you can see yourself going in advance is very low. … I also think that there is unfinished business with regard to clarity of objectives. I’ve been an advocate since the first day I came here of a formal inflation target, and that issue is still unresolved. There is a huge amount of unfinished business in trying to define and communicate the Fed’s reaction function.

 think that, to too great an extent, we’ve been throwing information out there without being clear in our minds what the message is. … And the way I’ve made this point in several speeches is that the issue is not transparency, but communication. Transparency implies that you throw back a curtain and let everybody look in. We too often dump the data without explaining what to make of it and why we’re doing it. What we need to do is not increase the material that we put out there, but we need to increase the interpretation and explanation, and we need to clarify the message. I don’t think there is enough of that happening.

That speech [March 2003] caused a little stir. I don’t think anything constructive by way of reform has happened since. I don’t take credit for disclosing the accounting irregularities, but when I look back, is there something I wish I had said or not said? The answer is no. One of the reasons I went down that track is that I have a vivid memory when I was at the Council of Economic Advisers in Washington. We had many discussions and were all very well aware of the problems being covered up in the savings and loan industry. That experience led me to rather deep regret that I had not raised that issue publicly. I might not have been in a position to do it because it was a very politically difficult issue, and many people were trying to cover it up, sweep it under the rug and ignore it. But I wish I would have somehow found a way to raise that issue and improve public consciousness. If I had been able to do that in 1982 or 1983, and if there had been some earlier action, it might have saved taxpayers quite a bit of money. It probably wouldn’t have made any difference, but I would have felt better.

I would not expect the Federal Reserve Act to be opened and revised in any important respect in the absence of a significant monetary problem.  ... From time to time, there will probably be some attacks on us from Congress. That happens. But if we continue to perform pretty well on the macroeconomic front, I don’t think we’re going to be very vulnerable, and the attacks that occur from time to time will not have any material effect on the law. That means that the Federal Reserve banks will shrink in terms of their operating responsibilities. I think we need to get used to the prospect of Reserve banks being smaller in terms of employment, and more vigorous and more rigorous in terms of our intellectual output.

To start with, central bank credibility and low and stable inflation expectations are of critical importance. Earning that confidence is the most important thing the Fed can do in dealing with shocks as they occur. If the Fed doesn’t have that underlying confidence, then all sorts of things can go wrong and, indeed, the Fed may find itself willy-nilly taking policy actions intended to maintain or restore credibility rather than dealing with the current problem, whatever it might be. So, most of the work in dealing with the crises comes before they even happen. Where the Fed is now is a consequence of earning that credibility starting with Paul Volcker and then dealing successfully with a whole series of issues during the Volcker, Greenspan and now Bernanke eras.

It is appalling where we are right now. [The Fed has introduced] a backstop for the entire financial system.

"The Fed will want to be as low-key and invisible as possible and that means the Fed will not want to change the funds rate ahead of the election," said William Poole, who retired in March as president of the St. Louis Federal Reserve Bank after a decade on the Fed's rate-setting committee.

"But I believe that if there is a compelling case, the Fed will do so," he said. "I do not believe the Fed will abstain from necessary policy action because of the election."