For release: July 12, 2002
Contact: Joe Elstner, (314) 444-8902

Low Inflation Expectations in Long Run Aid Fed's Flexibility in Short Run: St. Louis Fed's Poole

Link to speech

ST. LOUIS -- At a time when long-run expectations of low inflation are well established, the Federal Reserve need not be hypersensitive to short-term inflation concerns. The reason: The Fed's credibility as a long-term inflation fighter gives the Fed room to adjust policy to reduce unwanted fluctuations in employment and output.

That was the view of William Poole, St. Louis Federal Reserve Bank president, in a speech to the Midwest Region of the Association of State Treasurers.

"The Fed has room to act, but does it have the knowledge to act?" said Poole "It's been well documented that forecasters, including those at the Fed, have great difficulty predicting the turning points of business cycles, or even recognizing them soon after they occur. So, the best that can be reasonably expected is that the Federal Open Market Committee (FOMC) would be able to initiate policy actions several months in advance of cycle turning points, or to adjust policy due to accumulating evidence to help reduce the magnitude of a recession."

Poole noted that the most recent business cycle was an example of that process. "The business cycle peak was March, 2001," he said. "The FOMC started lowering the intended federal funds rate at the beginning of January, 2001, a two-month lead on the turning point." He added that the FOMC had indicated in its policy statement after the December, 2000 meeting its concern that the economy might be weakening.

"As was made clear in the FOMC's published minutes over the course of last year, the committee did not foresee the extent of the downturn," Poole said. "But over the year, it did sense the continuing weakness and did respond readily to incoming information suggesting that the expected revival of activity was not occurring."

Poole observed that when the terrorist acts occurred, the economic outlook suddenly looked much worse. The Fed cut the intended fed funds rate sharply further, he said, and bond rates fell to what turned out to be their lows for the year. "The economy, though, did not sink sharply," Poole said. "Prompt action by the Fed and the resilience of the U.S. economy carried us through. As data arrived in October and November indicating that housing remained very strong and auto sales were responding vigorously to auto company incentives, the outlook turned brighter."

Poole said that because the Fed is increasingly transparent about its objectives and methods of analysis, financial market participants understand how the Fed interprets economic data and the market can forecast Fed policy actions more precisely. "In fact, the market can forecast these actions with about as much precision as the Fed can forecast its own actions." he said.

As to an outlook for the economy, Poole noted that "the prevailing view is that the economic expansion will continue and that its pace will pick up from that of recent months. That expectation is reflected in the current level of long-term interest rates. Although the 10-year Treasury rate is down more than 50 basis points from its March level, that decline should, in my view, be interpreted as evidence that the market believes that the odds are lower than before that the recovery will proceed so rapidly that the Fed will be required to tighten policy relatively quickly. The important point, though, is that the market believes that the recovery will continue."

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