The problem with the recent data, including the CPI and PPI, is that the price increases are becoming more broad-based. Thus it is becoming harder to view the increases as isolated relative price shocks that will dissipate over time. While not all the increases are big, they are showing up in more things. The more widespread are the price increases, the more it begins to suggest there are underlying inflationary pressures out there.

...It’s mostly nominal demand driven, whether it be nominal domestic demand or global demand. We’re getting conflicting signals on demand but it’s something we have to watch carefully. It may be evidence that monetary policy had been too easy.

Since the October FOMC meeting, financial conditions have deteriorated, and we have seen some unexpected softening in the economic data. These developments necessitate some rethinking of my growth forecast, and have highlighted the downside skew in the risks to that forecast. On the inflation front, I continue to expect core consumer prices to rise at a pace that is broadly consistent with price stability, although there are some notable upside risks that bear careful watching and consideration. Additional data bearing on the outlook will become available before the FOMCs meeting next week, and this information must also be factored into an assessment of the economys prospects.

On the inflation front, the data since early spring have been encouraging. Inflation rates excluding food and energy have been stable, while headline measures have moved up and down with energy price fluctuations. Moreover, inflationary expectations have remained fairly well anchored. While I did not, and do not, take this as evidence that inflation is no longer a risk, it is encouraging.

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We also cannot rule out the possibility that the Fed’s reduction in the fed funds rate target runs the risk of higher inflation and inflation expectations. While the inflationary signs in recent months have been encouraging, I do not think we are in a position to be sanguine. If inflation begins to creep up or expectations of future inflation rise in the coming months – which is a risk given the FOMC’s decision to cut interest rates – the outlook will be affected and policy may have to be adjusted.

The Committee projected overall and core inflation to be in a range consistent with price stability next year.  Supporting this view were modest improvements in core inflation over the course of the year, inflation expectations that appeared reasonably well anchored, and futures quotes suggesting that investors saw food and energy prices coming off their recent peaks next year. 

In addition to growth, I'm keeping a close watch on prices. Readings on inflation have improved this year, and I believe that inflation will most likely continue to moderate as measured by so-called core inflation indices. But there are some inflationary risks. In particular, recent increases in energy and commodity prices, among other factors, could put renewed upward pressure on headline inflationthe inflation you and I encounter in the marketplace.

In voting to ease policy, I carefully considered the effect of that decision on our other objective--price stability. I reasoned that the anticipated softening of economic growth and perhaps the emergence of some slack in the labor market might reduce those pressures, and I judged that a cut of 25 basis points in the target federal funds rate would not materially alter that modal outlook. However, I recognized the risk that, even if readings on core inflation have improved modestly this year, recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. Consequently, in considering appropriate future adjustments to policy, I will monitor inflation developments carefully.

Overall, I think that the cumulative policy easing the FOMC put in place at its past two meetings reduced significantly the downside risks to growth so that those risks are now balanced by the upside risks to inflation. In these circumstances, I will want to carefully assess incoming data and gauge the effects of financial and other developments on economic prospects before considering further policy action. As always, my colleagues on the FOMC and I will act to foster our dual objectives of price stability and sustainable economic growth.

if in fact the more likely scenario unfolds in which conditions improve and risks recede, then policy should be prepared to respond to any developments that threaten the inflation outlook. Indeed, not all of the risks to the economic outlook are on the downside.

[O]ur baseline forecast sees soft economic activity this fall; notably, it is likely that a further sharp decline in residential investment will weigh on the top-line growth numbers. But we see growth recovering next year and moving up to average close to potential later in 2008, which we at the Chicago Fed currently see as being somewhat above 2-1/2 percent. This lower potential number in part reflects an assumed trend in productivity growth that is slower than the trend we experienced over the 1995-2003 period. Nonetheless, the new productivity trend is still a healthy one by longer-term historical standards and, accordingly, should support income creation, job growth, and household and business spending. Solid demand for our exports should also be a plus for growth. Although we expect a small increase in the unemployment rate, labor markets in general should remain healthy. Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast.

With regard to inflation, we do not see any large movement one way or the other from current levels of core price inflation. Here the risks seem two-sided. With no appreciable slack in resource markets, cost pressures from higher unit labor costs, energy, or import prices could show through to the top-line inflation numbers. However, weaker economic activity would tend to mitigate the potential for this. ... At present, my outlook is for core PCE inflation to be in the range of 1-1/2 to 2 percent in 2008-09. Relative to our outlook six months ago, this is a favorable development.

Just several months ago, the twelve-month change was quite a bit higher, at nearly 2½ percent. It wouldn’t surprise me if core PCE price inflation edged down a little bit more over the next few years. This view is predicated on continued well-anchored inflation expectations. It also assumes the emergence of some slack in the labor market, as well as the ebbing of the upward effects of movements in energy and commodity prices. However, we do still face some inflation risks, mainly due to faster increases in unit labor costs and the depreciation of the dollar, and these will need to be watched carefully.    

Currently, I believe long-term inflation expectations remain anchored, and measures of current inflation have decelerated during the year from elevated levels in 2006. ...  Going into the Sept. 18 FOMC meeting, my opinion was that the balance of risks to the economy had shifted from higher inflation toward slower real growth. I believed, and still do, that the factor weighing most heavily on this change in the outlook has been the potential negative ramifications of the financial turmoil.  

We will also have to remain vigilant on the inflation front. The reduction in the funds rate runs the risk of higher inflation and expected inflation in the future. While the inflationary signs this summer have been encouraging, I do not think we are in a position to be sanguine. If inflation begins to creep up or expectations of future inflation rise in the coming months – which is a risk given our decision to cut rates – the outlook will be affected and policy may have to be adjusted.

As I look at the incoming inflation data, I would judge them to be consistent with expectations in this range; moreover, I believe that having expectations reasonably well anchored in this range has been a helpful influence on the path of actual inflation.  However, let me be clear: I do not subscribe to a deus ex machina view of the inflation process, in which inflation is driven solely by inflation expectations and is little influenced by the balance of aggregate demand and aggregate supply.  Indeed, I take the view that expectations of future resource utilization are also an important factor affecting inflation outcomes.

If households and businesses believe that the Federal Reserve will set monetary policy in a way that keeps aggregate demand in reasonable alignment with aggregate supply over time, then expectations of future resource utilization will be stable, and current resource utilization will provide less information about future inflation movements.  In that situation, which I believe describes the current environment, inflation expectations will be a key driver of inflation dynamics.

I anticipate that the core PCE price index will edge down slightly further over the next few years.  This view is predicated on continued well-anchored inflation expectations.  It also assumes the emergence of some slack in the labor market, as well as the ebbing of the upward effects of several special factors-including energy and commodity prices and owners' equivalent rent.    

I believe there are still reasons to remain concerned about the risks to the inflation outlook. First, there are indications that the recent improvement may have been transitory, and that we may see inflation remain at this level, or perhaps even move up again. Second, the public's expectations of future inflation – an important determinant of inflation trends – appear to be inconsistent with further reductions in inflation.