It was once widely held that monetary policy could achieve somewhat lower rates of unemployment by allowing somewhat higher rates of inflation, and that it could do this without risking a  BIS Review 54/2006  1  substantial acceleration of inflation. This view proved to be mistaken because it did not correctly account for the role inflation expectations played in inflation dynamics. Economic concepts that are critical to our understanding of the economy may be difficult or impossible to capture in practice. One such concept is the neutral or equilibrium interest rate, which is the rate that, if sustained over some period of time, is likely to be consistent with an economy growing at potential with low inflation. Plausible estimates for the prevailing level of this rate have a range of at least 100 basis points, and the center of the estimates tends to move around quite a bit. Another concept that is difficult to estimate precisely is the economy's potential, or sustainable, growth rate. The acceleration in productivity growth in the United States in the late 1990s, for example, led us to revise our estimates of how fast the economy was likely to be able to grow at that time without undermining price stability. We also face considerable ignorance about the precise channels through which policy actions ultimately affect the economy, as well as how long those effects will take to show up and how large they will be when they do show up.
The issue of communication is particularly relevant in the current economic environment. For much of the past three years, financial markets have reflected a high degree of certainty about the near-term outlook for monetary policy in the United States. Market expectations in the weeks preceding each of the last 16 Federal Open Market Committee (FOMC) meetings attached a probability close to one that the FOMC would raise the target for the federal funds rate by 25 basis points. Also, there was very little probability attached to inter-meeting moves over this period, or to moves in increments larger than 25 basis points. And, although market expectations about how far the FOMC would ultimately move were revised significantly over the course of this period as the economic outlook was revised, these changes occurred without the Committee needing to deviate from the near-term path. This period of unusual certainty in the path of the fed funds rate was the result of a confluence of factors. When the Committee first moved to tighten policy in June 2004, the fed funds rate was at the historic low of 1 percent, and it was clear that policy would have to move a substantial distance to get back within the range of plausible estimates of the neutral rate. Over the course of the following months the incoming data tended to reinforce the case for a progressive move up in the target rate.