Read the entire speech on the Cleveland Fed website. Here is the part people will be talking about.
The important thing to recognize is that, unless energy prices continue to grow at the rate we saw this summer — something I consider very unlikely — their effects on the overall rate of inflation should prove to be temporary. The inflation statistics we see in the near term may look discouraging. However, most professional forecasters — the Blue Chip forecasters, the Congressional Budget Office, and others — share my expectation that inflation should moderate substantially next year.
Looking forward into 2006, the most probable course for the economy after the hurricanes is very close to the course that seemed likely before the hurricanes. We are likely to have a moderately expanding economy, in which the headline inflation numbers gradually slow down and move into line with the much-lower core inflation rate.
Likely, that is, if monetary policy does its part to keep those temporary pressures from translating into more persistent inflation. Temporary inflation will turn into longer-term inflation only if the FOMC allows expectations of persistent inflation to build. The key question is what course monetary policy should take to keep inflationary expectations from taking hold.
That brings me to my outlook for monetary policy. I have come to think of monetary policy as a plan — a plan that contemplates the many paths that the economy might take, and that formulates an appropriate response in anticipation of those possibilities.
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We have continued with that plan of removing policy accommodation over the past year-and-a-quarter, as we have adjusted the federal funds rate target from 1 percent to 3.75 percent. As I said, Katrina and Rita did not change the broad contours of my forecast for continued economic growth and lower inflation into 2006. So, to me, the plan of continuing to remove the remaining amount of policy accommodation still looks like a sound one.
We have already removed a substantial amount of that accommodation, and it is fair to ask how much further we might have to go. Although the hurricanes did not change my best estimate of future economic activity, they did — as our last FOMC minutes indicate — increase the degree of uncertainty surrounding that estimate. The answer to how much higher the federal funds rate needs to go depends on how economic conditions unfold. So, let me share my thinking about a couple of possibilities that I have been contemplating.
First, it is possible that consumers will retrench their spending by a greater degree, and for a longer period of time, than we expect. Households have yet to experience the full impact of the recent energy-price increases, especially in the form of higher home-heating bills this winter. The long run-up in energy prices could finally prove to weigh heavily on consumers and significantly reduce their spending on non-energy items. In that case, the economy could become fragile and further increases in core inflation could prove to be even less of a worry than today. If consumer spending and inflation pressures appear to be weakening across the country, then the appropriate federal funds rate might prove to be lower than it would be otherwise.
Alternatively, total spending could bounce back more strongly than I anticipate — while at the same time consumers, businesses, and financial markets react to sustained increases in energy prices by raising their longer-term inflation expectations. In this case, a higher federal funds rate may be required, so that monetary policy does not unintentionally support an inflationary environment - one in which prices for a broad range of goods and services steadily rise.
Monetary policymaking requires managing risks. That means having a plan that is flexible enough to take into account sudden surprises and changing conditions. While I may be uncertain about which path the economy will take, I am clear about the goals of the central bank. I believe being prepared means, first and foremost, being in a position to respond if threats to price stability arise. Removing the remaining monetary policy accommodation puts us in the strongest possible position to react as evolving economic conditions require.
Like economists are so fond of saying, "It depends." Kash's post today falls into the same category. Will consumers cut back on non-energy purchases when heating costs go up this winter? Will the labor market be strong enough in that environment for people to ask for wage increases? The ultimate level at which the funds rate will reach in this tightening cycle depends on those and other factors.
UPDATE: The Beige Book is up at the Fed's website.
UPDATE: Reuters summarizes the day's speeches.
Links to speeches by Donald Kohn and Richard Fisher.
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