San Francisco Fed's Yellen on Prospects for Growth and Inflation in 2006

Janet Yellen reflects on the economy over the past year and the prospects for growth, high employment, and inflation in the coming year. She also discusses the future of monetary policy and I will focus on that part of her remarks:

The U.S Economy: 2005 in Review and Prospects for 2006, By Janet L. Yellen, San Francisco Fed President: ...As 2005 draws to a close, it's a good time to take a look back at the year that has passed and to think about what may lie ahead for the U.S. economy in 2006. ...I'm going to organize my remarks around three broad topics. The first is employment and output growth. The second is inflation. ... My third and last topic is the conduct of monetary policy ...

Looking back at 2005, clearly one of the most dramatic events was the one-two punch of Hurricanes Katrina and Rita. ... Recent data suggest, however, that consumer spending has held up well so far. ... [F]or now, at least, it appears that the national economy has come through the twin shocks of the hurricanes and the year and a half long escalation in energy prices quite well. Concerns about downside risks to the economy seem much smaller than just a few months ago. This is definitely good news, but uncertainties do remain—especially during a period like this, when the stance of monetary policy is changing. It's inherently difficult to judge the exact magnitude and timing of the effects of removing policy accommodation. Therefore, it will be very important to monitor this situation in the months ahead, particularly if, as seems likely, there is cooling in the housing market and other interest-sensitive sectors. ...

[T]he Federal Reserve is ... keenly focused on maintaining price stability. ... [T]he so-called PCE price index. ... has jumped to 3.3 percent over the last twelve months, reflecting large increases in energy prices. However, ... so-called core inflation, which excludes the energy and food components. ... is up by a much more moderate 1.8 percent over the twelve months ending in October. I have previously enunciated that, in my view, core PCE inflation in a range of 1 to 2 percent constitutes an appropriate price stability objective for the Fed. Since 1.8 percent is in the upper portion of this comfort range, I'd be happier if this measure were somewhat lower. And, indeed, it is lower if we look over a shorter horizon. ... This suggests to me that core inflation has been essentially compatible with the Fed's price stability objective, even in the face of a rather large oil shock that started well before Katrina. Looking ahead, I'm generally fairly optimistic about the future for inflation, though I do think there are upside risks—mainly having to do with energy prices—that require vigilance ... With regard to energy, it's certainly a good sign that—so far—higher energy prices have not been passed through to ... core prices to a significant extent. I want to emphasize the "so far" part of that statement, because a any sign of a more significant pass-though would be a concern for monetary policy. One need only think of the 1970s to know what I'm referring to. ...

This brings me to my last point, the conduct of policy. Clearly, for monetary policymakers, the public's confidence in our commitment to price stability is a very helpful thing. ... [W]ell-anchored inflation expectations themselves are likely helping to contain the inflationary pressures ... How has the Committee established credibility? First, ... inflation has come down markedly over the past twenty-five years and stayed low for quite some time. ... In keeping with this strategy, at the November meeting, the Committee voted to continue its gradual removal of policy accommodation and raised the federal funds rate target to four percent. The objective of this policy action—as well as any future actions—is to position the economy on a trajectory characterized by "full employment" and price stability. ... In addition to actions such as this, I believe the Committee has reinforced its credibility with the public by becoming more transparent and focusing on communication. ... Transparency is helpful not only in building credibility, but it is also helpful in another important way. By letting everyone in on its current thinking, the Committee helps to align expectations, including those in financial markets, with its best estimate of where policy is likely to go. ...

I believe ... clarifications and signals about future actions help... avoid confusion about the Committee's perspective and contribute... to making policy more effective. [T]he sentences about where policy is likely to go reflect the Committee's best estimates. And best estimates, of course, are always subject to revision. So I want to emphasize that, in my view, the Committee must always have the flexibility to respond to changing circumstances. ... For example, in November, the statement said "the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability." If you look at the minutes from the November meeting, you will see that the statement is currently a subject of discussion. Two phrases in particular are at issue: "remove accommodation" and "at a measured pace." While it seems unlikely that the end of the current tightening phase is yet at hand, there obviously will come a time when these two phrases are no longer appropriate, and other changes to the statement may be needed as well. As the November minutes suggest, going forward, the Committee will pay close attention to incoming data and weigh options carefully in assessing the stance of policy and the wording of the statement. ... I believe that this public confidence has strengthened under Chairman Greenspan's leadership of the Fed... I'd like to close by saying that public confidence is also a very valuable thing—and like all valuable things, it is hard to win and easy to lose. For my part, this must mean ensuring—in both deeds and words—that ... our economy does not suffer from an unacceptable rise in inflation.

This speech gives the impression that Yellen is ready to stop increasing the target federal funds rate if incoming data indicate that core inflation is not being pushed upward by higher energy prices. However she also made it clear that any sign of inflation will be met aggressively.