"A key factor in low long-term interests rates is that inflation
expectations have been anchored at low levels, so lenders are not
concerned about finding their returns wiped out by an acceleration of
inflation," Stern said. "That is one reason why I think it's important
(the Federal Reserve) remain committed, as I have suggested we are, to
low inflation."

     Despite the economic downturn, Stern doesn't see a return to the
environment of the early 1980s, when the Federal Reserve sharply
increased interest rates. He says people at that time felt nothing could
be done about double digit rises in inflation and expected it to
continue for years to come. "I think (current) inflation expectations
are pretty well anchored at low levels. ... I don't foresee a return to
that environment at all," he said.

From audience Q&A, as reported by Market News International

Although most of the recent concern about the U.S. economy has been focused on growth, we must also be mindful of inflationary pressures. The recent news here has been somewhat disappointing. We have experienced large increases in food and energy prices, and other commodity prices are high; in addition, we are hearing numerous anecdotes of firms passing on cost increases to their downstream customers... [I]f outsized increases in food and energy prices persist, then core becomes a less useful medium-term guide to inflation trends. Furthermore, persistent food and energy price increases will find their way into inflation expectations, which in turn would boost core measures. So the recent developments in food and energy prices are a concern that deserve careful monitoring. That said, our forecast is for inflation to moderate over the next two years.

I believe that accommodation is appropriate because the financial shock and the housing cycle have significantly restrained economic growth. While growth seems likely to be sluggish this year, the Fed’s policy actions should help to promote a pickup in growth over time. I consider it most probable that the U.S. economy will experience slow growth, and not outright recession, in coming quarters. At the same time, core consumer inflation seems likely to decline gradually to somewhat below 2 percent over the next couple of years, a level that is consistent with price stability.

However, economic prospects are unusually uncertain. And downside risks to economic growth remain. This implies that, going forward, the Committee must carefully monitor and assess the effects of ongoing financial and economic developments on the outlook and be prepared to act in a timely manner to address developments that alter the forecast or the risks to it.

Yesterday, Plosser said rate cuts have been ``necessary and appropriate'' in response to a weakening economy. He told reporters he was concerned reductions could lead to accelerating inflation. ``That is the price you can pay if you become too aggressive,'' he said.

As reported by Bloomberg News

When energy prices go up, it pushes inflation up, and we face a choice whether to counteract that or not. When the futures market's telling you that they're going to flatten out, it doesn't look like there's as much to counteract. But we've been surprised on the positive side by energy prices for four years in a row now. At some point you just have to ask the question of whether the futures markets are a reliable guide and whether we need to do more to offset the effect of energy prices on the overall level of inflation.

From press Q&A as reported by Market News International

Inflation expectations seem to be fairly contained right now. The upward movement we see does not at this point seem to be likely to result in runaway inflation.

From press Q&A, as reported  by Market News International

A slowing economy requires a lower real interest rate because it means softer relative demand for resources now compared to the future. And the current downside risks mean that further slowing, and thus further easing, is quite possible. But inflation also presents risks. Throughout the period since 2005, when inflation rose, eased off, then rose again, longer-term inflation expectations have remained fairly stable. If energy and food prices continue to push overall inflation above core inflation, then this higher overall trend could work its way into expectations, further complicating monetary policy in 2008.

I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.

I am also troubled by the lengthy divergence we've seen between overall and core inflation. Some of you may recall that core inflation was devised in the 1970s to filter out some of the more volatile consumer prices to get a better read on inflation trends. For several decades, core inflation seemed to work well due to the fact that food and energy prices had no clear trend relative to the overall price level. In the last few years, though, overall inflation has been persistently above core inflation, and few observers expect oil prices to go back below $20 per barrel. Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation. Going forward, markets expect oil prices to back off slightly from their current level, and I hope they are right this time.

For 2007, the consumer price index increased 4.1 percent—the largest calendar-year increase since 1990. The core CPI (excluding food and energy costs) increased 2.4 percent, which is above my comfort zone.

Stable expectations allow us if we so choose to go slow with policy adjustments because when the evidence comes in we can catch up. Or, if we respond too much from a Monday morning quarterback standpoint, we don't create any lasting problem, because inflation expectations are entrenched and therefore the market doesn't run away with expectations.

From press Q&A, as reported by Market News International

Consequently, we must remain vigilant on the inflation front and be prepared to act as necessary to avoid the risk of undermining public confidence in the central bank’s commitment to price stability.

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.

There are also important reasons to be concerned about the outlook for inflation.  Although recent readings on core inflation have been favorable, prices of crude oil and other commodities have increased.  These changes most likely will put upward pressure on overall inflation in the short run.  Moreover, the decline in the foreign exchange value of the dollar could lead to higher prices for imported goods.  If these same forces cause inflation expectations to become less reliably anchored, then inflation could increase in the longer run as well. 

Those of us responsible for crafting U.S. monetary policy cannot afford to be distracted by the flux of short-term price changes that are destined to be unwound. Our eye should be focused on underlying inflationary pressures, some of which may indeed be coming from food and energy markets. Routinely excluding food and oil price movements from our inflation gauges may have made sense in the 1970s, the 1980s and even the 1990s—but not now, nor in the next few years. The conceptual beauty of trimmed mean inflation measures lies in their ability to capture steady increases in food and energy prices, which may be germane to the pursuit of price stability, while excluding the temporary spikes and dips that do not presage changes in the underlying inflation rate. 

The sustainable or long-run trend growth rate of the economy is an important benchmark in calibrating the stance of monetary policy. In general, economies that grow faster exhibit real, or inflation-adjusted, interest rates that are somewhat higher than those of slow-growing economies. Monetary policymakers must be cognizant of that fact in setting the target for the fed funds rate. Failure to do so would likely result in the creation of either too much or too little liquidity, leading to too much or too little inflation or perhaps even deflation.