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

A variety of expectations measures then, point to expectations for core PCE inflation of about 2 percent right now. What does this imply about the outlook for actual inflation, which is now running at about 2¼ percent? The current level of inflation expectations is likely to exert a gravitational pull on actual inflation, if monetary policy actions are not inconsistent with those expectations and no concerted effort is made to shift expectations...

Could inflation fall below 2 percent, say to 1½ percent? That depends. Without a prompt fall in inflation expectations, a reduction in inflation below 2 percent is likely to be temporary and hard to sustain. With expectations left alone, the remaining mechanism for bringing down inflation is the traditional Phillips curve mechanism, that is, an increase in real interest rates that slows aggregate demand and reduces both inflation and real activity...

The prospects for bringing inflation down below 2 percent thus hinge on the extent to which a reduction in inflation expectations can be brought about. How difficult would that be? Using changes in the target interest rate alone, the process is likely to be difficult and time-consuming...

One natural approach to bringing inflation expectations down more expeditiously, should that be the desire, would be a strategy of clear communications about policymakers' intentions.

We cannot afford to go back to a world similar to the 1970s, where shocks that should have had only a transitory impact on inflation—whether due to oil prices, rents or movements in the dollar—shift longer-term inflation expectations and touch off a self-fulfilling wage-price spiral. The Fed’s commitment over the last two decades to keeping inflation low has fundamentally changed inflationary psychology and that has permitted both inflation and unemployment to be low and stable. Keeping inflationary expectations well anchored is essential to good outcomes for the economy overall.

Given my estimate of the current level of long-run inflation expectations as well as the likelihood of some easing of resource pressures in labor and product markets, I expect that core inflation will slow to around 2 percent over the next couple of years.    

More fundamentally, I believe that long-run inflation expectations remain a key determinant of the path of inflation. But what are the current expectations for long-term inflation? Unfortunately, that is not an easy question to answer. The results from the Survey of Professional Forecasters, readings on household opinion such as the Reuters/Michigan survey, and the spread between standard Treasury securities and Treasury inflation-protected securities--taken together--suggest that long-term inflation expectations are currently around 2 percent, although this guess is far from certain.

Given my estimate of the current level of long-run inflation expectations as well as the likelihood of some easing of resource pressures in labor and product markets, I expect that core inflation will slow to around 2 percent over the next couple of years. Although I believe that inflation expectations will play a primary role in determining the course of inflation, I want to emphasize that neither economists nor policymakers understand the expectations-formation process very well.

The best way to achieve the mandate is for the Federal Reserve to have a strong commitment to a nominal anchor to promote price stability, but with a focus on keeping employment as close as possible to its maximum sustainable level.  

To paraphrase the late Milton Friedman, inflation is always and everywhere an expectational phenomenon.  To put it another way, inflation expectations are an outcome of monetary policy, not an autonomous help or hindrance.  Central banks are as responsible for the behavior of inflation expectations as they are for the behavior of inflation.  

[T]he data suggest to me that long-run inflation expectations are currently around 2 percent.  That said, I think it should be clear that the evidence points to a range of estimates; moreover, this range is itself uncertain because of the assumptions needed to tease point estimates from the available data.  So, although I think that 2 percent is a reasonable estimate of current long-run expectations, I don’t want to overstate the precision of this figure.  We still face some uncertainty in this regard, and policymakers must be cautious about placing too much confidence in any one estimate.  

Anchoring of inflation expectations is not a deus ex machina. It must come from somewhere, and since Milton Friedman’s adage that “[i]nflation is always and everywhere a monetary phenomenon” is still true, monetary policy must be the source of the change in the evolution of long-run inflation expectations.

If long-run expectations are in fact about 2 percent, where is actual inflation likely to be headed in the next year or two? While recognizing how embarrassingly wrong such prognostications often turn out to be, I think that we can be reasonably optimistic that core PCE inflation will gradually drift down from its latest twelve-month reading of 2-1/4 percent...

Looking to the medium term, I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy. For the most part, this assessment--which I should stress is subject to considerable uncertainty--flows from my view that long-term expectations appear to be well anchored at a level not very far below the current rate of inflation. If so, a substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming to bring about, as I noted earlier.

The forces behind currency competition that have bolstered incentives for central banks to maintain low inflation and so have helped anchor inflation expectations are likely to persist and perhaps strengthen.  The ease with which funds move across capital markets should continue to ensure that the responses to inflationary central bank policies will be swift and significant.  The resulting incentives provided by currency competition should continue to foster relatively low far-forward nominal interest rates in many countries.  As long as capital markets remain open and people remain aware of the costs of high inflation policies, I believe that the forces behind the low level of long-term interest rates and hence the general flatness of yield curves around the globe will tend to persist for some time.  

The issue of expectations illustrates our ignorance.  As I have already indicated, inflation expectations are among the most important variables policymakers monitor, but we do not have answers to our most basic questions about them:  Are available measures suitable indicators of true inflation expectations by households and businesses?  How are expectations formed--and in particular what are the respective roles of central bank talk, central bank actions, and actual inflation outcomes?  And how do expectations influence price and wage setting?  In short, although I believe that inflation expectations are critical to assessing the inflation outlook, I cannot be sure (particularly in real time) that our expectational measures are accurate and so cannot know what precise role expectations play in wage and price dynamics.  

While it may be too soon to declare this research issue entirely settled, my sense is that the preponderance of empirical evidence suggests that price setting is predominantly forward-looking.

But there is uncertainty and then there is uncertainty. I am fairly confident that the public places an extremely low probability on the Federal Reserve allowing inflation to average 10 percent over the next decade...  On the other hand, I suspect that market participants place some probability on inflation remaining at around where it is now — a 2 ¼ percent core PCE price index, for example — rather than moderating to 1 ½ percent. In that sense, one might question whether inflation expectations are anchored close enough to the price stability shore. Three-quarters of a percent might seem like a relatively small difference in inflation rates, but sustained over a decade or two, it would amount to a material difference in purchasing power.

The broader lesson to take away from this Report is that inflation dynamics have evolved significantly over the last 50 years, and inflation expectations appear to be forward-looking. To again paraphrase the late Milton Friedman, inflation is always and everywhere an expectational phenomenon.