Energy prices have dropped sharply over the past month and the prices for many other commodities also have softened. And with the unemployment rate still high and capacity utilization low, resource slack is likely putting downward pressure on prices. In addition, market measures of longer-run inflation expectations are at the low end of the range they have been running since last November. 2  BIS central bankers’ speeches  Putting these factors together, my outlook is for overall inflation over the medium term to fall back towards core and remain below the 2% level I see as consistent with the price stability leg of the Fed’s dual mandate. Monetary policy and the dual mandate In my view, central banks should focus on medium-term inflation. Over shorter periods, measured inflation rates are affected by all sorts of short-term influences, such as fluctuations in food and energy prices that are beyond the control of monetary policy. Furthermore, there are significant lags before policy actions influence inflation. So reacting too strongly to short-run influences simply adds noise to the policy-making process. So, by this appropriate standard I think inflation likely will be below our goal of 2%. And of course, unemployment is much above its natural rate. Thus, at the moment, there is little conflict between our two goals. Both suggest at least some additional monetary policy accommodation would be helpful.
“An Historical Analysis of Monetary Policy Rules,” in John B. Taylor (ed.) Monetary Policy Rules, University of Chicago Press. BIS central bankers’ speeches  3  modern treatments is due to John Taylor in an article published in Econometrica in 1979.3 This framework continues to be a mainstay of optimal policy analysis, as evidenced by a large literature that includes work by Michael Woodford in recent years.4 Taylor expresses the central bank’s dual-mandate objective as monetary policymakers attempting to minimize the weighted sum of squared deviations of inflation and the level of output from their goal values. That is, a central bank attempts to minimize a simple quadratic loss function like the following: L = (π – π*)2 + λ * (y – y*)2 Here π and y are inflation and the (natural) logarithm of output, and π* and y* are the policy goals for these variables. In most formulations, y* is the log of the level of potential output – the level of output at which resource slack has a neutral influence on the level of inflation. Thus, (given the properties of logarithms) y – y* is the usual output gap, the percentage difference between actual and potential output. And π – π* is the gap between the actual and desired rates of inflation. Ideally, we’d like both of these gaps to be zero, but this usually won’t be the case.