What are the prospects for inflation over the next year or two? When I look at all of the elements that influence inflation, it seems that the most likely outcome over the next year or so is that inflation will remain contained, although there are risks, and I think they are tilted slightly to the upside. First, there is the possibility that inflation could intensify if labor and product markets continue to tighten. Next, there are risks relating to energy and commodity prices. Apparently, we haven't had much in the way of pass-through from past increases in energy and commodity prices to core inflation yet, but I wouldn't be surprised if some modest amount were evident in the next couple of quarters. Assuming, however, that energy and commodity prices level out, and, importantly, that longer-term inflation expectations remain stable, I would expect any pass-through of earlier increases to boost core inflation only temporarily.

Long-term interest rates are not rising because of an increase in inflation expectations, he said, and instead indicate a "vote of confidence" in the expansion.

Researchers using measures of inflation expectations derived from bond market data find that long-run inflation expectations in inflation-targeting countries are remarkably stable and well-anchored, while in the United States long-run inflation expectations have been highly sensitive to economic news.

Although the evidence from surveys and financial markets is admittedly mixed, taken together these studies suggest that announcing a numerical price stability objective and greater transparency in general could help further anchor long-run inflation expectations. My personal view is that the steps that we have already taken toward greater transparency have been a good thing, and that we should think seriously about venturing further along this path

I support the idea of a quantitative objective for price stability. I believe that it enhances both Fed transparency and accountability and that it offers important benefits, as I have discussed. In particular, it could help to anchor the public's long-term inflation expectations from being pushed too far up or down, and thus help avoid both destabilizing inflation scares and deflations; a credible inflation objective could thereby enhance the flexibility of monetary policy to respond to the real effects of adverse shocks.

Econometric evidence suggests, however, that the pass-through of energy prices to core inflation has dropped by more than would be implied by the decline in energy intensity...

Although many factors could have led to these results, a likely explanation is that inflation expectations have become better anchored. In the 1970s, monetary policy unfortunately allowed large increases in energy prices to have a persistent effect on inflation, a policy that undercut the Fed's credibility and caused long-run inflation expectations to be more volatile.

Over a short period, then, higher inflation might bring lower unemployment, consistent with the empirical results found by Phillips. However, this logic applies only during the period in which wages and workers' expectations of inflation are fixed. If inflation were to rise persistently, Friedman and Phelps argued, workers' expectations of inflation would not remain unchanged but would adjust to match the actual rate of inflation...This work was both brilliant and prescient. In particular, among the seminal contributions of the Friedman and Phelps analyses was the identification of the key role of inflation expectations in determining the behavior of the economy, a point that remains central to our thinking today.

More recently, the evidence has mounted not only that low and stable inflation is beneficial for growth and employment in the long-term but also that it contributes importantly to greater stability of output and employment in the short to medium term. Specifically, during the past twenty years or so, in the United States and other industrial countries the volatility of both inflation and output have significantly decreased--a phenomenon known to economists as the Great Moderation (Bernanke, 2004). This finding challenges some conventional economic views, according to which greater stability of inflation can be achieved only by allowing greater fluctuations in output and employment. The key to explaining why price stability promotes stability in both output and employment is the realization that, when inflation itself is well-controlled, then the public's expectations of inflation will also be low and stable. In a virtuous circle, stable inflation expectations help the central bank to keep inflation low even as it retains substantial freedom to respond to disturbances to the broader economy.

Inflation pressures increased in 2005. Steeply rising energy prices pushed up overall inflation, raised business costs, and squeezed household budgets. Nevertheless, the increase in prices for personal consumption expenditures excluding food and energy, at just below 2 percent, remained moderate, and longer-term inflation expectations appear to have been contained.

Another key factor in keeping core inflation low has been confidence on the part of the public and investors in the prospects for price stability. Maintaining expectations of low and stable inflation is an essential element in the Federal Reserve's effort to promote price stability. And, thus far, the news has been good: Survey measures of longer-term inflation expectations have responded only a little to the larger fluctuations in energy prices that we have experienced, and for the most part, they were low and stable last year. Inflation compensation for the period five to ten years ahead, derived from spreads between nominal and inflation-indexed Treasury securities, has remained well anchored.

Inflation is low and stable, and the public appears to be fairly confident that inflation will remain persistently low and stable.

Providing quantitative guidance to the public about the Committee’s long-run inflation intentions would have the benefit of reducing uncertainty about future monetary policy, and more securely anchoring long-run inflation expectations.

The 20th century saw a gradual but steady departure from the gold standard, culminating in the closing of the U.S. “gold window” in 1971. It is not surprising that expectational stability would have been lost around the same time. When inflation was observed to rise in the 1970s, the public saw no obvious mechanism in place for bringing it back down, and so higher inflation became built into people’s long-run expectations.

Inflation expecations have become "well anchored" to price stability--most likely because people are confident that the Fed will act to limit any potential rise in inflation.  This may account for research results suggesting that, during this period, energy price increases have generally not been passed through to core inflation.

There is another worry, however. If we indeed start to see a string of higher inflation numbers, then people may begin to expect permanently higher inflation. ... Fortunately, current financial market data and consumer surveys suggest that long-run inflation expectations remain contained.