Thank you, Mr. Chairman. The economic news since the last meeting has certainly been grim, and our presentation today bore that out. Our directors and other District contacts are quite gloomy, and their reports are also consistent with a broad-based pullback in discretionary outlays by consumers and firms.
In these circumstances with the funds rate around 1/8 percent, it is hard to see a benefit of prolonging any further reduction. I agree with the staff analysis that any potential dislocation in money market institutions is likely to be minor, and I observe that, to the extent that money market institutions provide value to the economy in the form of circumvention of prohibitions on interest and other legal restrictions on financial arrangements, the traditional welfare analysis would count their demise as a benefit rather than a cost. But I have to admit I haven’t tried explaining that to a money market fund manager. [Laughter]
The hard question now, I think, concerns the possibility of deflation. We have seen negative overall inflation since energy prices peaked in July—it was 1.8 percent for the PCE at an annual rate since then and 4½ percent before today’s release for the CPI—and the core indexes have softened notably as well. I still think we are going to be able to avoid this fairly easily, but I do not think the risk is negligible. It is one of the most dangerous prospects we face right now, and we have to pay very close attention to it. The reason I think it is going to be easy to avoid is that we have seen declines in core inflation before when energy prices fell—mid-2005 and late 2006 are recent examples. Further, compensation growth does not yet appear to be slowing rapidly, although those data are fairly dated and so it is hard to sense what the last couple of months are going to look like. The key to avoiding deflation, of course, is our ability to shape expectations about the future course of monetary policy. I had a spirited discussion about this last night over salad with Governor Kohn and Mr. Eggertsson. This is essentially what all the models tell you—that staying out of a deflationary equilibrium requires commitment to paths for the monetary base that are inconsistent with a steadily falling price level and that commitment to keeping the nominal interest rate low is not sufficient.
Now, it is sort of hard to get a handle on this. It took me a while, but the key to thinking about this is that models with Taylor-type rules embed within them the perfect credibility of inflation returning in the long run or over a medium term to the targeted rate that is built into the Taylor reaction function. If instead you take those models and just allow arbitrary fiscal and monetary policy rules, that is when you are forced to face the result that committing to an infinite series of zero nominal rates is not sufficient and that you have to keep a monetary aggregate from declining along with the price level.
One way to think about this is that it is just like preventing inflation. To prevent inflation, we have to prevent expectations that the value of money will fall in the future. To rule that out, we have to rule out expectations that the quantity of money is going to rise continually, and we do that with interest rates. This line of reasoning is different from the reasoning you get in a Phillips curve with purely backward-looking expectations, where you have a recursive relationship between real growth and inflation. Instead, in any model with a little forward-looking stuff, you have expectations driving things. Preventing deflation is the same thing—preventing expectations that the value of money will rise indefinitely. To do that you need to prevent expectations that the quantity of money will fall indefinitely, and you would like to do that with low interest rates, but you cannot at the zero bound. So you have to influence expectations about the future course of the base. This to me is the simple intuition for that. All of this is just to suggest that our ability to communicate is going to be crucial.