Looking ahead, prognosticators this year have divided into several different camps. Some believe that high unemployment necessarily will lead to continually falling inflation for several years, and they are concerned about the risk of outright deflation. I personally have thought the risk of deflation was overstated, and for the first three months of this year, inflation has averaged 2 ¼ percent – both core prices and overall prices. Another camp places significant weight on the public’s expectations, and as near as we can figure, those are fairly well anchored around 2 percent. And finally, a third camp sees the rapid growth in our balance sheet, notes the historical association between rapid money growth and subsequent inflation, and wonders whether inflation will accelerate when the economy begins to recover.

Where do I stand? While I gravitate to the second camp – the one that views stable expectations as likely to anchor inflation in the near term – members of the third camp have identified inflation risks that are quite legitimate. The challenge for us on the Federal Open Market Committee will be to shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation. The danger is that we will not shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation. Choosing the right time to withdraw that stimulus will be a challenge, and I believe it will be very important to avoid the risks of waiting too long or moving too slowly.

I see little basis to worry that we will develop an inflation problem. There is more of a reason to think that we could experience some deflation, but the chances of a severe bout of that ailment seem remote.

[I]f economic growth resumes in the United States as I expect, the threat of deflation should diminish commensurately... As for liquidity provision and inflation, it is important to emphasize that the relation between growth in the money supply and the path of prices holds in the long run, over periods of at least five and more likely 10 years. Thus, there is ample time for the Federal Reserve to withdraw excess liquidity as appropriate.

The extent of a decline in inflation...should be limited by the relative stability of longer-term inflation expectations.  That said, there are sizable risks on both sides of the inflation forecast.
On the one hand, we cannot rule out the possibility that adverse economic conditions will cause deeper cuts in prices, a greater softening in wages, and a steep decline in inflation expectations.
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On the other hand, the Federal Reserve's actions to ease credit conditions have resulted in a tremendous increase in its assets and in bank reserves.  Some observers have expressed concern that these actions, if not reversed in a timely manner, are sowing the seeds of a sharp pickup in inflation down the road. ..[W]e are working with the Treasury to introduce legislation that would enlarge our tool kit for moving away from the extraordinary degree of financial stimulus we have put in place when the time arrives.

[A]s far ahead as I trust my forecasting ability[5] (that is to say, the next couple of years), the problem with regard to maintaining price stability most certainly is not inflation.

Right now, because of the weakness in economic conditions here and around the world, inflation has been running less than that, and our best forecast is that inflation will remain quite low for some time. Thus, the Fed's proactive policy approach is not at all inconsistent with the goal of price stability in the medium term.

I consider inflation an evil spirit that rots the core of economic prosperity and must never, ever be countenanced. But it is clear to me that in this environment, inflation is unlikely to present a serious threat given the pervasive bias in the U.S. economy toward wage cuts and freezes, rising unemployment, the widespread loss in wealth that has resulted from both the housing and equity market corrections, continually declining consumption and business investment, and the anemic condition of the banking and credit system, all of which reinforce downside price pressures in a global economy groaning with excess capacity.

Over the longer-run, with appropriate monetary policy, I see both overall and core inflation averaging somewhere into the neighborhood of 2 percent, which is a rate I see as being consistent with price stability. That said, there is notable risk that inflation will remain a good deal below this range in the medium term.

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[A]t a time when near-term inflation is likely to be lower than usual, endorsing an explicit numerical objective for inflation could help keep inflation expectations from falling very far. Such an anchor on inflation expectations would help preserve low real inflation-adjusted interest rates.

 The Committee's aggressive monetary easing was not without risks.  During the early phase of rate reductions, some observers expressed concern that these policy actions would stoke inflation.  These concerns intensified as inflation reached high levels in mid-2008, mostly reflecting a surge in the prices of oil and other commodities.  The Committee takes its responsibility to ensure price stability extremely seriously, and throughout this period it remained closely attuned to developments in inflation and inflation expectations.  However, the Committee also maintained the view that the rapid rise in commodity prices in 2008 primarily reflected sharply increased demand for raw materials in emerging market economies, in combination with constraints on the supply of these materials, rather than general inflationary pressures. 

(W)hile inflation is receding for the moment, I must remind you that monetary policy is extremely accommodative, and if it remains so too long, as history suggests it may, inflation pressures could re-emerge as the economy recovers.
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Inflation will remain moderate over 2009 and much of 2010.  Lower energy and commodity prices along with moderate improvement in demand for goods and services will keep price pressures temporarily contained.  How prices behave beyond the immediate horizon depends most critically on how the Federal Reserve conducts policy and manages its expanding balance sheet in a strengthening economy.  This is no doubt the central bank's most difficult long-run challenge.

The potential for real interest rates to rise as inflation declines creates a significant downside risk because, with an extended period of abnormally high unemployment in the forecast, it is increasingly likely that inflation will fall to undesirably low levels. This is an additional consideration that, to my mind, militates in favor of strong policy responses.

While the downturn in real economic activity is going to pose challenges for monetary policy in the period ahead, it’s essential that we not let inflation drift from view. Since 2004, overall inflation has trended upward, and has been higher than I would like, over the last few years. Much of the acceleration we saw earlier this year reflected energy prices, however, and with oil prices down we have seen overall inflation subside in recent months.

Many economists are forecasting relatively low inflation in the months ahead, on the grounds that widening economic slack is generally associated with declining price pressures. While this correlation is detectable in many datasets, I would be cautious about relying on it as a causal relationship.⁵ And while it may seem premature to be worrying about how inflation behaves after the recession is over, we need to be sure our policy remains consistent with a strategy that does not allow inflation to ratchet up over the business cycle.

"We don't expect deflation," Richmond Fed chief Jeffrey Lacker told reporters after a speech to the Tech Council of Maryland.

With the federal funds rate at a low level of 1% and the economy weakening, many Fed watchers have begun to discuss other means of boosting the economy, also called "quantitative easing."

Lacker seemed confident that the Fed has sufficient ammunition, saying that the U.S. central bank has "a wide variety of choices" with which to conduct policy even if interest rates were lowered to zero.

"I don't see our inability to reduce the funds rate below zero as hampering our ability to make monetary policy," he commented.

As reported by Market Watch.

The near-term economic outlook is not encouraging. The incoming data in September and October have been worse than expected, and these results pushed my staff and me to revise downward the Atlanta Fed's outlook for the economy.

I foresee substantial weakness at least through the first half of 2009. This weakness will exacerbate the employment picture. In my outlook, unemployment will rise some more.

If there is anything positive in this near-term outlook, it is the trajectory of prices. I expect headline inflation to decline over the coming months and fall into an acceptable range below 2 percent by 2010. Over the longer term, inflation experience is influenced by inflation expectations. Encouragingly, the University of Michigan consumer survey's reading for October shows a moderation in inflation expectations both for the year ahead and for the longer term.

Many analysts expect the U.S. economy to regain positive momentum sometime in 2009. That strikes me as a reasonable expectation, for several reasons. First, monetary policy is now quite stimulative. The federal funds target rate is 1 percent, below the expected rate of inflation. Second, the major shocks that dampened economic activity this past year have already subsided or are in the process of doing so. Energy prices, thankfully, have reversed most of the earlier run-up; that will free up a portion of consumer budgets for spending on other goods and services. And as I've mentioned, the drag from housing seems likely to lessen in the next year, and in fact, I would be surprised if we don't see a bottom in housing construction around the middle of 2009. This is the third straight year, however, that I've been expecting a bottom in the housing market in the middle of next year, so my outlook is tempered by more than the usual amount of humility.
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The sharp decline in oil prices since they peaked this summer has flattened the overall inflation rate in August and September. Many economists are forecasting a decline in core inflation as well in the months ahead, on the grounds that widening economic slack is generally associated with declining price pressures. While this correlation is detectable in many datasets, I would be cautious about relying on it as a causal relationship.⁴ In particular, this relationship can shift over time as expectations about the conduct of monetary policy evolve. Those expectations will be influenced importantly by the measure of monetary stimulus provided during the downturn and how long that stimulus remains in place. As a recovery begins, the path of least resistance is often to hold the policy rate at a low level until it is completely clear that recuperation is complete. The risk associated with that path is that inflation may not moderate obediently during the downturn, and may firm with the ensuing recovery. It is crucial that we not allow expectations of future inflation to ratchet higher during this recession.