Anchored inflation expectations damp the pass-through of supply-related price shocks.  They also permit central banks to respond more forcefully to output fluctuations.  Most significantly, the improved inflation performance has come with, not at the expense of, output stability.  Although a consensus has not formed on how much of the "Great Moderation" in the growth of real output can be attributed to monetary policy, everyone agrees that at least a portion of it can.

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.

Mr. Plosser said some of the decline in core inflation — which excludes food and energy — during the spring, to 1.9% by the Fed’s preferred measure, was "transitory." Nonetheless, he said, “I can’t see core in the latter half of 2007 being much more than a little over 2%."

As reported by the Wall Street Journal

Our objective is to achieve enduring price stability. And in particular we want to make sure that inflation remains under good control in the medium run.

There are several elements of that. One is that I think it's important to recognize that the month-to-month inflation numbers are very noisy. And so, a couple of good numbers does not, by itself, meant that the problem is solved and gone away.  So part of it is just simply seeing more data and getting a greater sense of assurance that the trend is really in the direction we'd like to see it.  The other is that as long as there's some very important risks out there to inflation, there's the possibility that inflation, even if it's a bit -- if it's come down some, there's a possibility that it will go back up in the future.

And the risks that I talked about in my testimony include high resource utilization, the fact that the economy is working at a very tight use of resources; and secondly, the fact that energy and food prices have raised headline inflation. Those prices might feed through into core inflation. They might raise inflation expectations.  So what we need to see is enough confidence that the risks have subsided so that we can feel confident that, in the medium term, inflation will be well-controlled.

In response to a question from Senator Bunning in the Q&A session

Over the three years leading up to 2006, real growth in the U.S. economy was relatively rapid, and inflation remained relatively low and stable. Over the course of 2006, though, both those numbers deteriorated a bit. Growth dropped below 3 percent, and in fact was closer to 2 percent in the last half of the year. Meanwhile, inflation moved above 2.5 percent. While still relatively low by historical standards, I view that number—and, more importantly, the upward trend in inflation—with some caution. Inflation is, in my opinion, too high.

But given the repeated swings [in inflation] we've seen, it is difficult to pick out a definite trend, and in fact, no statistically significant moderating trend has emerged yet.

Turning to inflation risks, the high level of resource utilization continues to have the potential to put additional upward pressure on inflation.  And, of course, higher oil prices and the possibility of further increases also pose an upside risk to inflation.  With these concerns in mind, the latest statement issued by the Federal Open Market Committee again highlighted the risk that inflation could fail to moderate as expected, and I believe that the risks to the inflation outlook are primarily to the upside.

[T]he level of output relative to potential output, which is referred to as the output gap, plays an important role in the inflation process.  When the actual level of output is above potential output--so that the output gap is positive--labor and product markets are excessively tight; then, if things such as expected inflation and temporary supply factors are held constant, inflation will tend to rise.  Conversely, when the output gap is negative and labor and product markets are slack, inflation will tend to fall. 

For better or worse, we cannot escape the need for information on output gaps so that we can forecast the future path of inflation and evaluate the current setting of our monetary policy instruments.  However, we also need to recognize that because measures of potential output and output gaps are so uncertain, we must always be aware that they might be providing misleading signals as to the future course of inflation and the appropriateness of the stance of policy.  In assessing whether there is slack in the economy, we at central banks look not only at our estimates of output gaps but also at a wide range of indicators drawn from the labor, product, and financial markets to provide us with a perspective on the balance of supply and demand in the economy...

The bottom line is that we must never take our eye off of the inflation ball. 

I'd like to see [core] inflation rates running lower at this point and more toward the center of that [1 to 2 percent] zone.

As reported by Bloomberg News

"We can't take our eye off the ball" on inflation. "I'm uncomfortable with inflation running about 2 percent," referring to the core price index for personal consumption expenditures.

As reported by Reuters

We're accustomed to finding the roots of inflation in too much money chasing too few goods. For too long, however, we've brushed aside the issue of whose goods. Just our own? At one time, maybe -- but not in today's globalized economy.

In teaching inflation's causes and cures, economics professors have for generations invoked the famous Equation of Exchange. With mathematical clarity, it tells us that prices are directly linked to the amount of money in circulation and the speed at which we spend it. So print money faster than the economy grows and the value of a dollar will fall.

Luckily, transaction velocity remains relatively stable over the years, allowing us to conclude that inflation mainly depends on money growth, an instrument of policy, and the pace of economic expansion.

But we're now in an age of globalization. Freer movement of goods, services, people and ideas stretches production to the far reaches of the planet. China, India and other newcomers with huge labor resources and productive capacity are becoming important players. Each year, the part of our economy isolated from global competition becomes smaller.

It seems unlikely that inflation would remain a purely domestic affair in our globalizing economy. Research by a handful of economists like Harvard's Ken Rogoff has found important links between foreign production and U.S. inflation. The empirical studies are changing some minds on the subject of globalization and inflation, but we also need new doctrine -- an equation of exchange for the new economy.

[O]ne recent study even purports to show that foreign output gaps are more important in explaining domestic inflation in industrialized countries than domestic factors (Borio and Filardo, 2006). However, this result has been challenged by the Federal Reserve staffers, who find that estimates to this effect are fragile.⁷

[T]he reduced sensitivity of core inflation to oil and natural gas prices likely also reflects both the increased energy efficiency of the economy and the fact that shocks to the prices of these goods since the mid-1980s have, at least until the latest episode, been viewed as mostly temporary. In contrast, the rise in oil prices during the 1970s was probably seen at the time as largely reflecting a permanent shift in global demand/supply balances.

I expect the economy to continue to operate at a high level relative to its potential, which could eventually lead to the emergence of increased inflationary pressures. In addition, if actual inflation does not show clear enough signs of returning to the center of the range I associate with price stability, there is a danger that expectations of inflation could run too high, which would likely be a self-fulfilling prophesy. Taking all of these factors into account, my assessment is that the risk of inflation remaining too high during the forecast period is greater than the risk of growth falling too low. Thus, some additional firming of policy may yet be necessary to address this inflation risk.