In my mind, current circumstances and a weighing of alternative risks mean that a balanced policy approach calls for being extraordinarily patient in reducing accommodation – that is, being patient about when we first increase the federal funds rate and being patient about setting the pace of rate increases once we have begun to move. Proceed cautiously in normalizing policy The first factor entering my analysis is that I see a number of downside risks to the growth and inflation forecasts. For instance, as I look around the globe, I see many economies facing slow growth and low inflation. Europe and Japan are well-known cases among the advanced economies. Of course, slow or stagnant growth in advanced countries has negative spillovers onto emerging markets that are highly dependent on exports for their growth. Indeed, today China is confronting slower growth, and the Brazilian economy has fallen into recession. For the United States, slower growth abroad reduces demand for our exports and, with it, U.S. production. In addition, weakness abroad could translate into a higher exchange value for the dollar against other currencies, further reducing net exports. A higher dollar also would result in lower prices for imports, which, in turn would hold down inflation and delay progress toward our 2 percent inflation target. While the risks to the U.S. outlook emanating from abroad are worthy of notice, they are not the biggest thing on my mind.
Lessons for monetary policy With regard to monetary policy, in many respects recent events have served to confirm the approach adopted by the ECB since the outset of Monetary Union in 1999. Most fundamentally, the primacy of price stability as the objective of monetary policy has been confirmed. Indeed, at times of financial stress, the credible maintenance of price stability becomes even more important. Were the anchoring of inflation expectations to weaken, financial market tensions would intensify further and corrective measures would prove less effective. Moreover, our recent experience of financial crisis – with its roots in the evolution of bank balance sheets, and thus monetary and credit developments – has vindicated in my view the importance attached by the Governing Council to a close and regular monitoring of the monetary data. In the design of the ECB’s monetary policy strategy, it was always foreseen that the close monitoring of monetary developments would provide a framework for policy makers to consider asset price developments and potential misalignments. Responding to monetary and credit dynamics as part of a comprehensive assessment of the risks to price stability in the medium term implies that interest rate decisions will tend to “lean against” accumulating financial imbalances and asset price misalignments. Recent research provides a vastly enriched framework for conducting such monitoring in a systematic fashion, and offers a real possibility that asset price disequilibria and associated financial distress may be identified at an early enough stage for corrective measures to be taken by the policy authorities.