Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you, Mr. Chairman. I am going to make my remarks a little shorter here. My judgment is that the current situation is a difficult one for the Committee. Because of the very appropriate focus on financial market turmoil over the past year, our attention has naturally turned away from keeping the level of interest rates consistent with longer-term inflation objectives. This was done to avert particularly extreme, but low probability, outcomes in which the economy would experience an especially severe downturn. As it turned out, the bad state did not materialize, which I think will go down in history as a successful element of the Committee’s policy over the past year. The ability to take on financial market turmoil of this magnitude and prevent it from doing substantial damage to the economy— a recession of the magnitude of 1980-82, let’s say—has been a real achievement. In that sense, all has gone according to plan. At the same time, we have moved interest rates to a very low level in the context of rising inflation and rising inflation expectations. A severe downturn was unwelcome, to be sure, but it was also projected to keep inflation in check. Since that did not materialize, we are left with low rates and an environment of CPI inflation running at 5 percent headline, measured from one year earlier, and long-term inflation expectations creeping higher. We face more risk now of creating a serious inflation problem than we have in a generation.

To make progress, I think we should keep rates steady today but with the plan of preparing markets for an increase in rates at the September meeting, conditional of course on incoming data. This would be consistent with alternative B today; and with intermeeting statements, it would move probability mass toward higher rates through the fall and through the first half of 2009. I have several remarks on a fall tightening campaign. First of all, moving 25 basis points is by itself not likely to have a large effect on economic activity, nor does it bring the level of the federal funds rate high enough to have a meaningful effect on inflation. The FOMC started tightening in mid-2004 but achieved a core CPI inflation rate below 2 percent in only one month during the entire three-year period of 2005, 2006, and 2007. What the move would do is get the Committee started on returning interest rates to a more normal level, a level more consistent with our inflation objectives. The Committee could pause or even reverse course should particularly adverse data suggest that economic activity was weakening substantially. Preparing for an increase in rates means that we would be signaling that financial market turmoil is no longer the paramount concern. On that, I think we can reasonably stress that we have provided accommodation over the past year in the form of lower interest rates and innovative liquidity facilities. We have bought time for financial firms to repair and adjust. While all is not as it was, we do not want to create an inflation problem in the aftermath of a shock of this magnitude, which may actually compound the situation and make it worse.

Longer-term inflation expectations have been creeping higher, a fact that has been widely cited in commentary on monetary policy. I would like to stress that, in my view of a well- functioning inflation-targeting regime, these inflation expectations would not be moving at all. Short-term interest rates would be moving higher and lower in response to shocks to the economy, and inflation expectations would never move. This would reflect the confidence that the central bank’s short-term interest rate adjustments were being accomplished in just the right way to offset disturbances buffeting the economy. Because of this, I prefer not to interpret observed movements in inflation expectations as evidence of what we should or should not do with respect to interest rates. The short-term interest rate would have to move to offset the shocks to the economy even if longer-term inflation expectations never moved. Thank you.

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