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Conducting Monetary Policy at the Zero Bound: Rules, Learning, and Risk Management

Speaker: William C. Dudley, President and Chief Executive Officer, Federal Reserve Bank of New York
Presider: Richard H. Clarida, Professor of Economics and International Affairs, Columbia University
May 24, 2012, New York
Council on Foreign Relations

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RICHARD CLARIDA: We're going to get started right on time. CFR runs a tight ship.

My name is Richard Clarida. I'm a professor at Columbia University, and I'll be presiding over this event today. So welcome to today's meeting with William Dudley, who's the president and CEO of the Federal Reserve Bank of New York.

The meeting is part of our C. Peter McColough Series on International Economics.

I'm reminded to remind you completely turn off, not just put on vibrate or pause, your cellphones, BlackBerrys and all wireless devices, to avoid interference with our sound system.

I'd like to remind the members that this meeting is on the record. CFR members from around the nation and the world are participating in this meeting via a password-protected teleconference. And I'm asked to remind you that our next meeting will be on Thursday, May 31st, with Senator Marco Rubio of Florida.

Well, today's speaker, as I mentioned, is William Dudley, who is the president of the Federal Reserve Bank of New York. He's been in that capacity since January 27th, 2009. As the saying goes, may you live and preside in interesting times, and he certainly -- he certainly has.

And of course for many years before that, Bill was a major figure at Goldman Sachs, in thought leadership, in international economics, and then served in between as vice president of the markets group.

So without ado, I turn it over to President Dudley, and then we'll have some time for questions. Thanks.

WILLIAM DUDLEY: Well, I expect my remarks today are going to be a little different than Governor (sic) Rubio's. (Chuckles.)

(Laughter.) So it's a great pleasure to have the opportunity to speak here today. I'm going to focus on how I think about monetary policy in today's challenging economic environment.

As part of this, I'm going to discuss how simple policy rules might be used as a guide to decision-making. I do this not because policy rules are in a dominant role in my own thinking but because the use of these tools is widespread, with many forming their arguments this way. To start with the punch line, although I believe simple policy rules can provide useful input into the policymaking process, it would be unwise to rely on them mechanically.

As always, what I have to say today reflects my own views and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.

Policy must strive to promote the dual mandate objectives of maximum employment and price stability given to the Federal Reserve by Congress. I believe that this should be done in a transparent and systematic manner because this will help us achieve our objectives. In particular, a well-articulated framework for policy that explains our goals and how we will use our tools to promote these goals helps market participants, businesses and households to anticipate how the Federal Reserve will respond under different circumstances and plan accordingly. This helps to anchor private sector expectations in a -- ways that makes it easier to achieve our dual mandate objectives.

In contrast, if we acted in an unpredictable way, policy would be ineffective at anchoring expectations, and this shortcoming would disrupt the transmission of monetary policy to the real economy.

Now over the years this logic has led the Federal Reserve to become increasingly transparent and systematic in its decision-making. In January, for example, the Federal Open Market Committee took another important step in this direction, endorsing a public statement of longer-run goals and of monetary policy strategy. This document articulated a 2 percent inflation objective and committed the FOMC to a balanced approach with respect to promoting the dual mandate objectives.

For me, the key issue now is how to interpret these principles and to put them into practice. I interpret the strategy document itself as a relatively straightforward proposition. The Fed should seek to achieve the policy setting that generates the best path back to full employment and price stability following shocks that push us away from either of those objectives.

I regard the policymaking process as a systematic effort to investigate what policy setting would deliver the best of economic outcomes, taking into consideration all available information, including risks not fully summarized in our base case point forecast.

Now our approach is not greatly different from those of central banks that operate inflation targeting regimes, but in our case we explicitly seek to promote both aspects of our dual mandate.

The basic question is how should the FOMC implement policy to best push the economy back to its dual objectives. Prescriptions from simple policy rules such as the Taylor rule, from investor -- Stanford economist John Taylor, has a legitimate role to play in this evaluation, as do more complex simulations, such as the optimal control rules.

Now in the Taylor rule, the nominal federal funds rate depends on the equilibrium or neutral short-term low rate of interest, the deviation of the level of economic activity from estimates of the level of economic activity that would be consistent with price stability and the deviation of inflation from the central bank's inflation objective.

The Taylor rule formation has a number of characteristics that do make it a useful input into the policymaking process. First, it very explicitly focuses the two parameters, the long-term inflation objective and the level of potential output consistent with that objective, that map directly to the Federal Reserve's dual mandate objectives.

Second, standard Taylor rules are self-equilibrating. They respond to economic shocks and forecast errors in a way that pushes the economy back towards the central bank's objectives.

Third, academic research shows that Taylor-type rules perform quite well across a wide range of economic models. This is important because we want rules that are robust -- that is, not overly sensitive to model-specific assumptions about how the economy performs or how households and businesses alter their expectations and behavior in response to changes in monetary policy.

Fourth, with respect to the United States, the most popular versions of the Taylor rule approximate how policy has actually evolved since the last 1980s, a period in which the Federal Reserve has been successful in keeping inflation in check. You have a packet in front of you containing some exhibits, and the first exhibit shows the Taylor rule relative to the actual federal funds rate. This suggests that the policymakers that were faced with economic conditions of that period weighted deviations from their goals in a manner that was similar to the weights used in these versions of the Taylor rule shown in Figure 1.

Now despite these attractive features, I don't believe that simple policy rules can take the place of in-depth analysis of economic conditions, the evaluation of alternative policy plans and ultimately policy judgment. While simple policy rules provide useful information to policymakers, their very virtue, simplicity, means they cannot capture all information that is relevant for policymaking. For example, such rules cannot easily incorporate asymmetric risks or financial stability issues.

Moreover, the usefulness of simple policy rules depends critically on the stability of the relations between monetary policy and economic outcomes. If the relationship between monetary policy and the real economy were stable over time, probably a relatively simple and unchanging policy rule would likely generate acceptable results. However, if the linkage between monetary policy in the real economy is more variable, as I believe it is, an approach that is more pragmatic and that updates the policy setting in a clear and systematic manner, based upon what the Federal Reserve learns over time, will be more effective.

In particular, that simple policy rule can generate poor macroeconomic outcomes when either the structure of the economy changes or the transmission mechanism of how monetary policy changes affect the economy change in a significant way. This could be whether the change is temporary or permanent.

If private sector economic agents -- that's -- that is workers, businesses and investors -- thought we would implement a particular policy rule regardless of the changes of this -- of this type, policy would not be effective at stabilizing private sector expectations in ways that promote the dual mandate objectives. This is particularly relevant, I think, in the -- in the unusual environment in which we find ourselves, the aftermath of a housing bust and a financial crisis.

In the current context, there's an additional complication that's extremely important. Simple policy rules implicitly assume that monetary policy is unconstrained and that the Federal Reserve can always push the federal funds rate second -- setting to the -- to the setting that the rule proposes, even if that setting were negative. By extension, they also assume that it's as easy to ease policy as it is to tighten policy.

But in practice this may not always be the case. Because our traditional tool, the federal funds rate, is already at its effective zero lower bound, we may want to react differently to a given economic outlook and set of risks than we would if policy were unconstrained. Now, we're certainly not completely constrained. We have additional tools, such as the balance sheet and forward policy guidance, that we can use to provide additional monetary policy stimulus. But these tools have costs as well as benefits.

Moreover we can not only empirically translate the impact of these policy instruments -- these special policy instruments that we use when we're at the zero level bound into interest-rate equivalents for the purposes of evaluating the use of simple rules. So, for many reasons, I focus my attention primarily on how we are progressing and expect to progress relative to our dual mandate objectives. In this context, simple policy rules are an input, but my judgment's also informed by the economic environment, what we learn about the responsiveness -- and about what we learn about the responsiveness of the economy to monetary policy.

Nevertheless, it is possible to translate my assessments of what we would should do on policy into a language that would be more familiar to those who think in Taylor rule-type of terms. Now recall in a Taylor-rule framework, there's five major parameters that can be adjusted. The first two parameters are the inflation objective and the estimated output gap. The third and fourth parameters are the different weights that are placed on deviations from output from its potential and from inflation relative to the Fed's objective. And the last parameter is the estimate for the neutral real short-term rate of interest.

That's why the Taylor rule generally is viewed as a fixed formula, its underlying framework insufficiently flexible that such a rule could be modified to reflect certain types of new information. So which values should we use for these five parameters? In the United States, the inflation objective is well-specified: a 2 percent annual rate for the personal consumption expenditure deflator. The FOMC has formally committed itself to that objective.

In contrast there is disagreement among FOMC participants about how far the U.S. economy is operating from potential. Our staff work at the New York Federal Reserve estimates that the long-term unemployment rate is about 5 percent. In contrast the central tendency in the most recent summary of economic projections is a bit higher at 5.2 (percent) to 6 percent, but that that degree of -- (inaudible) -- is not particularly wide. More difficult is the judgment about what weights do you put on deviations from output, from its potential, versus deviations of expected inflation from the Fed's inflation objective. This will differ among policymakers based on their views about whether the costs of deviations from each of these dual objectives and on the structure of the economy.

Now this debate can be summed up by looking at two of the most well-known versions of the Taylor rule: the original version put forward by Mr. Taylor, which is commonly referred to as "Taylor 1993," and a later version updated by other economists that Mr. Taylor himself has not endorsed, but which is referred to commonly as "Taylor 1999." The difference between the two is Taylor 1999 puts more weight on deviations of output from potential than does Taylor 1993. Thus, Taylor 1999 would lead to a later liftoff of the federal funds rate as the economy is returning back towards full employment.

Now which set of weights is better is really a matter of judgment. John Taylor prefers Taylor 1993 and my own thinking, when translated into Taylor-rule terms, favors the weights in the Taylor 199 (sic) formulation. I believe that Taylor 1999 is likely to perform better in achieving the Federal Reserve's dual mandate objectives. Compared with Taylor 1993, I think it can achieve significantly greater stability in (employment ?) without sacrificing the medium-term inflation objective or significantly increasing the variability of inflation outcomes.

Finally, the main parameter in the Taylor rule is the neutral real short-term rate. This is the interest rate adjusted for inflation that is viewed as neither stimulating nor slowing the economy. It's typically set at 2 percent. Although there's no reason why the neutral real rate cannot change over time, the 2 percent rate is typically plugged into the Taylor rule without further attention. Whether this is an appropriate thing to do is a critical question in today's economic environment. I will return to this a bit later.

So let me now discuss the economic outlook and examine some of the implications for monetary policy. In doing so, I will look at the results obtained by applying some variants of the Taylor rule and explain some of my concerns about using simple rules in a mechanical way for setting monetary policy.

As I see it, the U.S. economy is continuing to slowly -- to recover from the aftereffects of the housing boom and bust and the financial crisis. But the recovery has been disappointing. Indeed when you look back at the economic forecast over the last three or four years, it's notable that growth has systematically fallen short of the Federal Reserve's and of private sector forecasts. Despite what's been an unusually accommodative monetary policy by historical standards, the economy has grown at only a 2.1 percent annual rate over the last four quarters and the current blue-chip consensus forecasts shows only a very modest acceleration to 2.4 percent growth over the next four quarters. This is shown in Figure 2.

The headwinds retarding the recovery are well-known: consumer debt and deleveraging in response to the large losses in wealth, generated in large part by the collapse that we've seen in home prices; housing activity remains depressed for many reasons -- these include the large shadow inventory making its way through the foreclosure pipeline -- tight underwriting standards for new mortgage origination; and the sharp slowdown that we've seen in household formation.

Although the corporate sector as a whole is now reasonably healthy, there still is a significant constraint on the availability of credit to small business. Fiscal policy has become restrictive as state and local governments have cut expenditures in response to revenue shortfalls and the uncertainty about how Congress and the administration will address the 2013 federal fiscal cliff is likely to inhibit hiring and investment by business. Global economic growth has slowed as European activity has stagnated, and this is capping the demand for U.S. exports.

Now, on the brighter side, some of these headwinds do appear to be gradually subsiding. Employment growth has picked up somewhat, shown in Figure 3, and this should eventually lead to faster household formation and more demand for housing. U.S. banks are healthier so that credit conditions, while still tight, are gradually easing, and households appear quite far along in the deleveraging process by a number of important measures. For example, if you look at the ratio of household debt service to income, that's back to the levels last seen in the early 1990s as shown in Figure 4.

For these reasons, I expect that growth will gradually strengthen over the next few years. Nevertheless, significant downside risks do remain, especially those related to the challenges in Europe and how the potential fiscal cliff in the United States will be resolved after the fall elections. Even if these risks do not materialize, I anticipate only slow progress back towards full employment.

On the inflation side, in recent years our forecasts have been mostly more accurate than our forecasts on the growth side. And we have succeeded in delivering inflation very close to our 2 percent price stability objective through March as measured by the personal consumption and expenditure deflator. Over the past 12 months, overall prices have risen at a 2.1 percent annual rate and prices, excluding food and energy, have risen 2.0 (percent). So this is shown in Figure 5.

But price trends have been a bit stickier than one might have anticipated given the large amount of slack in the economy. Now some -- to some degree this likely reflects the fact that we have an anchoring exerted by stable inflation expectations that's actually holding inflation up slightly. But some of the price pressures can be attributed to other, what I view as more temporary factors: first, higher oil prices and gasoline prices in their pass-through into the costs of other goods and services; second, the upward pressure on (imputed ?) homeowners' rents due to the increased demand for rental housing; and third, higher import prices for goods, such as apparel. This presumably reflects many factors, including commodity price pressures and higher wage inflation in countries such as China.

Now some of these upward pressures on inflation do appear to be fading. Oil and gasoline prices have fallen in recent months. Apparel price inflation should gradually ease given the sharp drop we've seen in cotton prices. Owners' equivalent rent should also eventually stabilize as multifamily construction picks up and programs that shift real estate owned by banks to -- into the hands of investors so they can be rented out gear up.

More generally, there are several reasons to think that inflation will remain moderate and close to our objective. First and most obviously, the economy continues to operate with significant slack. Second, measures of underlying inflation show little upward pressure. In fact, one, the Federal Reserve Bank of New York's underlying inflation gauge is actually turning down. This measures uses a very wide set of variables to forecast the underlying inflation trend. This is shown in Figure 6. Third, it's hard to be very concerned about inflation risks when the growth rate of nominal labor compensation is so low and stable. It's noteworthy to me that the employment cost index has risen at only a 2.1 percent annual rate over the past four quarters and has shown no signs of acceleration. This is shown in Figure 7. Fourth, inflation expectations remain well-anchored, shown in Figure 8. This is critically important because inflation expectations are important driver of actual inflation outcomes.

So taking into account the current stance of monetary policy and all these factors, I anticipate that inflation will decline a bit to slightly below 2 percent over the next few years.

So what does this all imply for monetary policy? Well, I currently anticipate that the Federal Reserve federal funds rate target will remain exceptionally low -- that is, at the current level -- at least through late 2014. This policy setting is more accommodative than the setting prescribed by the Taylor '99 rule that I discussed earlier. Using the Federal Reserve Bank of New York's current staff forecast, the Taylor '99 rule, unadjusted for the Federal Reserve's balance sheet actions, implies liftoff in 2014.

But this is incomplete because it doesn't incorporate any adjustment for what we did in terms of our balance sheet. I estimate that the current balance sheet provides the equivalent of roughly 150 to 200 additional basis points of Federal Reserve easing. But as time passes and we come closer to the date when we start to normalize our balance sheet, this effect will gradually diminish. Putting these adjustments into the Taylor '99 formulation would pull the liftoff date forward to 2013. This is shown in Figure 9.

So while I believe, then, that the policy that best promotes the achievable path back to our dual-mandate objectives should be more accommodative than that implied by Taylor '99, adjusted or unadjusted, Taylor '99, like other simple rules, does not take into account two key considerations: first, the strong likelihood that the relationship between monetary policy and the economy has changed significantly following the financial crisis; and second, the need to apply a risk-management framework to policymaking or operating policy at the zero lower bound.

I don't believe that the standard Taylor '99 formulation is a good guide for policy right now because the neutral real rate assumption embedded in this rule of 2 percent just doesn't look plausible right now. This is important because the degree of stimulus depends not on the current policy setting -- in other words, the federal funds rate we choose -- but on the difference between the current level and the neutral rate.

So for example, a short-term rate that appears highly stimulative under standard assumptions may in fact be much less stimulative if we use alternate estimates of the neutral real rate. If the neutral real rate has fallen, as I believe it has, then the entire trajectory of short-term rates implied by Taylor '99 shifts lower, and this pushes back the liftoff date implied by Taylor '99 significantly.

So how strong is the evidence that the neutral real rate has fallen significantly, at least in the near term? Well, first and most importantly, if the neutral real rate really were 2 percent, then the U.S. economy should be growing faster, as monetary policy would be extraordinarily stimulative right now. If that's the case, why do we see such a lackluster economic performance? Thomas Laubach and John Williams have devised a means of estimating how the equilibrium real rate varies over time based on how the economy actually performs, and the estimate generated by their model for the first quarter of 2012 isn't 2 percent, it's 0.3 percent.

Second, we could identify good reasons why the neutral rate is depressed currently. The channels through which monetary policy stimulates the economy right now are weaker than normal. Monetary policy works through its effect on financial conditions that in turn influence economic activity. Thus the linkage between the policy setting and the economy can be affected by changes in the relationship between policy and financial conditions or by the relationship between financial conditions and the economy.

So let's consider the linkage between the policy setting and financial conditions first. In my view, the major components of financial conditions include the value of the equity market, the level of real interest rates across the yield curve, the level of credit spreads, the availability of credit, the exchange value of the dollar. There are certainly others that one might include, but I think these capture the major elements of financial conditions. And if you look at that set of financial condition indicators as a set, financial conditions do not appear currently to be unusually tight or easy in the aggregate.

For the equity market, as you look at Figure 10 I think the evidence is mixed. On one hand, the equity risk premium actually appears to be quite elevated relative to historical standards. And price-earnings ratios based on current-year expected earnings are not unusually high. On the other hand, if you -- based on evaluation measures using trailing 10-year earnings, the U.S. stock market evaluation may be a bit more stretched.

For interest rates, conditions are accommodative, no doubt about it. Real rates are unusually low, shown in Figure 11. For credit spreads, pretty neutral. The level is well within normal ranges, neither as narrow as in 2005-2006 nor as wide as during 2008 and 2009.

On credit availability, well, the good news, it is improving, but not enough to reverse very much of the sharp tightening in credit conditions that we saw in 2008 and 2009. This is shown in Figure 13. Credit availability remains unusually tight for certain sectors, such as housing and small business.

And finally, the dollar. Looks pretty neutral to me. The exchange value of the dollar remains in the middle of a long-run channel, shown as Figure 14, that I would characterize as a very gentle decline.

Similarly, there is evidence that the linkage between financial conditions and how a given setting of financial conditions affects the economy, that looks to be attenuated as well. The most obvious example of this is the housing sector. But the subdued overall rate of credit expansion for both households and businesses is also noteworthy. This has occurred despite a monetary policy that would be judged on its face as one of the most stimulative in history.

Finally, market expectations suggest that the equilibrium real rate of interest will remain depressed, so not just depressed today, but also far into the future. To me it's particularly noteworthy that the real forward interest rate expected five to 10 years in the future is currently only 0.3 percent and has been moving sharply lower recently. It is far lower than at any time in recent memory. This is shown in Figure 15. While this pattern likely reflects in part a very low (turn ?) premium, risk premium, it may also be driven by an assessment that the equilibrium real rate has fallen and will remain unusually low for several years.

Now, this evidence implies that the current circumstances warrant the use of a significantly lower neutral real short-term rate in the Taylor rule formulation. As economic conditions normalize, supported by an accommodative monetary policy, then the neutral real rate presumably will gradually rise back towards its long-run level over time. So for example, if we were to do this and adjust the Taylor 1999 rule for a zero-percent real rate, we could see that this pushes the time of liftoff pretty far into the future beyond 2014. This is shown in Figure 16.

Now, risk-management considerations also suggest that a more stimulative monetary policy than prescribed by the Taylor '99 rule is appropriate. In particular, simple policy rules implicitly treat the welfare losses generated in terms of deviations from the central forecast as if those losses are symmetric. While I don't believe that potential losses are currently symmetric, in my view the distribution of potential outcomes is currently skewed to the downside, reflecting the risk posed by developments in Europe and the impending U.S. fiscal cliff.

Moreover, the costs associated with such downside outcomes -- so what happens if we actually get them -- are likely to be considerably higher than the costs of realizing upside surprises. For example, consider two alternatives scenarios. First scenario, an economy that grows very quickly but starting with some genuine excess capacity, versus an economy operating well below potential that stagnates and pushes the U.S. economy into a liquidity trap.

In the first case, we have good tools to deal with this. As the economy moved closer to full employment, we could raise short-term interest rates and subsequently sell assets from our portfolio. By doing this, we would tighten financial conditions, slow the economy and, in short, remain on a path consistent with our dual-mandate objectives.

The losses to society from this scenario should not be very large, provided that we act in a manner that keeps medium-term inflation expectations in check. But the losses to society may be very high in the second case. That is because, as Japan has discovered over the past two decades, once in a liquidity trap, it is not easy to return to full employment and price stability. Pinned at the lower bound, we don't have as good a set of policy tools that we could use to push the economy back towards our dual-mandate objectives. As a result of this symmetry, upside versus downside, we should give somewhat greater weight to avoiding the liquidity trap outcome.

Now, embedded within the traditional Taylor rule formulation is an implicit return path back to full employment and price stability, as the FOMC has achieved in the past when faced with shocks that pushed economic activity below its potential. In the current economic cycle, I think it's apparent that the path back to the Fed's dual-mandate objective has been much slower than the one that the FOMC found acceptable in the past. Growth has consistently been disappointing relative to both our own and consensus forecasts. Recent performance and forecasts relative to the dual-mandate objectives suggest that standard rules calibrated in earlier times understate the degree of accommodation required to achieve the desired return path back to the dual-mandate objectives.

In my view, we should focus on how fast we are moving towards our employment and inflation objectives and be wary about the risks that we see along that path. If progress towards the mandated objectives is slower than desired, then this is telling us that monetary policy needs to be kept at a more accommodative setting for a longer time period than a standard rule would suggest. As downside risks continue to be present, the case for accommodation is even stronger.

Now, given our forecast of stable prices and a still-slow path back to full employment, there is an argument for easing further. But unfortunately, our tools have costs associated with them as well as benefits. Thus, making those considerations, we have to weigh those costs against the benefits in terms of further action.

As long as the U.S. economy continues to grow sufficiently fast to cut into the nation's unused economic resources at a meaningful pace, I think the benefits from further action are unlikely to exceed the costs. But if the economy were to slow so that we were no longer making material progress towards full employment, the downside risk to growth -- or if the downside risk to growth were to increase sharply or if deflation risks were to climb materially, then the benefits of further accommodation would increase, in my estimation. And this could tilt the balance towards additional easing.

Under such circumstances, further balance sheet action might be called for. We could choose between further extension of the duration of the Federal Reserve's existing Treasury portfolio or another large-scale asset purchase program of Treasurys or agency mortgage-backed securities.

Conversely, I would be willing to consider tightening policy at a somewhat earlier stage if growth strengthened sufficiently to materially improve the medium-term outlook and substantially reduce tail risks or if there was evidence of a genuine threat to medium-term inflation, including a rise in inflation expectations. In such a case, I would anticipate that the first step would bring in the late 2014 date of the policy guidance. This would effectively tighten financial conditions not only by changing the expected path of future short-term rates, but also by bringing forward the expected start of balance sheet normalization.

So to sum up, I see substantial advantages in behaving in as systematic a fashion as possible in setting monetary policy, but this shouldn't be done in a way -- this should be done in a way that fully accounts for any constraints on policy imposed by the economic environment, the presence of asymmetric risk and that allows us to learn as we go. The fact is that the economy is recovering after an unusually deep recession and severe financial crisis. We don't have much experience with this type of episode and how the economy is likely to perform. What we need to focus on is not what interest rate a given rule generates, but what policy setting can be expected to deliver the appropriate return path back to our dual-mandate objectives, the type of return path that standard Taylor rule formulations achieved in different economic circumstances in the past.

Thank you for your kind attention. I think Richard and I are going to have a little conversation, then we're going to open it up for some questions. (Applause.)

CLARIDA: OK, well, Bill, thank you. Thank you so much for that. A lot -- a lot of content there and a lot of important things. So I'll invoke my prerogative as presider to ask the first couple of questions, and we'll leave plenty of time for the -- for the audience.

I'm going to give you a chance to do something now. In 50 years some future economic historian will write the definitive monetary history of the 21st century, and this crisis and the Fed's policy response will be a big part of it. So looking into that camera now and knowing this is on the record, address that economic historian, that future Friedman and Schwartz in the year 2050, and convey what message you'd like about the Fed's response to the crisis, the decisions you had to make and, importantly, how now you expect to be exiting from these unusual measures -- to Alan Meltzer's grandson or Alan Blinder's. (Laughter.)

DUDLEY: Exactly. I think that -- you know, I think the Fed will be viewed, you know, with the benefit of hindsight as acting completely appropriately in the financial crisis. In other words, we've behaved completely within the bounds of the laws and regulations, you know, promulgated by the Federal Reserve Act and in a way completely consistent with the dual-mandate objectives given us by Congress.

But you know, extraordinary times demand extraordinary actions. And while, you know, some of the things that we did were deeply unpopular in some quarters, in my mind, they were absolutely necessary to prevent the collapse of the financial system and, with it, extremely bad outcomes with respect to our dual-mandate objectives.

I think, you know -- you know, the normalization process is -- you know, that story has yet to be written. I think we'll -- you know, obviously, we're going to do that in a -- in a -- in a prudent way and, you know, make sure that we continue to behave in a way completely consistent with our dual-mandate objectives. Obviously, the situation right now is made more complex by the fiscal cliff looming and events in Europe. But -- and I think the good news is the U.S. economy is in better shape now. The U.S. banking system is much stronger than we were back in 2008. So I think we're in better shape in terms of the way forward.

But you know, I think it's way premature to write the -- write the record.

CLARIDA: OK, next question I have is about the Fed's dual mandate and, obviously, both inflation and unemployment As you know, but as some in the audience may not know, one of the reasons the unemployment rate has been coming down is because of decline in labor force participation. Indeed, if you look at a chart, it really looks like a trend and not just a cycle. So how important is it to the Fed that the unemployment rate come down because of job creation versus a continued decline in the labor force? And how does that factor into the dual mandate?

DUDLEY: Well, I think the key issue -- I mean, there's been a decline in the labor participation rate, and the question is what's driving it. One thing that's driving it is probably demographics. You know, the aging of the population and the fact that older people have a lower participation rate than people in their 30s and 40s means that over time as the population ages, the labor force participation is coming down.

But the decline that we've seen in labor participation looks more rapid than what you can account for just by demographics. It seems to be, from my perspective, that we're actually seeing people that are discouraged right now for looking for work, who have temporally withdrawn from the labor force. Now, if that's the case, what that means is that the unemployment rate today at 8.1 percent may understate the degree of excess labor resources because if the labor market improves, then people who are discouraged, if they see more job opportunities available, could re-enter the labor force.

CLARIDA: And a follow-up to that before I turn it over to the audience: The core measure of inflation now is running right about 2 percent, and of course the Fed is now officially, since January of this year, an inflation targeter for headline. And so how do you in the Fed interpret core inflation at 2 percent with this excess capacity?

DUDLEY: Well, I think -- you know, I tried to address that a bit in the -- in the speech. I think that, you know, at the end of the day, you have to ask yourself the question, well, why are we at 2 percent, and are the factors that are pushing us to that 2 percent, are they -- are they temporary, or are they likely to prove more persistent?

When I look at why we're at 2 percent today, I mean, there's forces pushing on both sides. On one hand, the fact that inflation expectations are well-anchored -- that means if inflation falls below 2 percent, the inflation expectations being well-anchored pulls -- tends to pull you back upward. On the other hand, we have a number of temporary factors that I think are pushing against the slack in the economy. So the slack in the economy is tending to pull inflation down, but these -- some of these temporary factors are pushing in the opposite direction.

And some of them I cited in the speech -- you know, the higher oil and gas prices and how they filter through in the cost of other goods and services, some of the things that are happening in the emerging world in terms of higher wage costs and the increases in apparel cost caused by higher cotton prices -- some of these other factors, I think, are more temporary. And I think what will happen as we go forward -- we'll see that these temporary factors fade. Inflation will probably tend to come down a little bit, so we'll fall back below 2 percent. That's our -- that's our forecast.

CLARIDA: OK, well, I want to have plenty of time for the audience. So the ground rules are: When called upon, please stand; wait for a microphone and state your name and affiliation; please do limit yourself to one question, and make sure it's a question and not a speech -- (laughter) -- and keep it concise to allow other members to speak. And then finally, I'd like to remind national members to email their questions to national@cfr.org.

So who has the first question? Right there, please.

QUESTIONER: Hi, I'm Allison Schrager, Dimensional Fund Advisors. I don't know if I heard you right, but did you say that you think the natural rate is 5 (percent), 5.5 percent?

DUDLEY: I said the full unemployment rate is 5.0 percent, about 5 percent -- about -- (inaudible).

QUESTIONER: Does that -- does that mean you think there hasn't been a lot of structural unemployment now, or at the very least what the Fed can control?

DUDLEY: I would say that the work that we've done suggests that -- the idea that there's a lot of structural employment -- we think those arguments are a bit overstated.

We've gotten some very careful look at what's, for example, happening to construction workers. You know, one of the stories about -- that the structural unemployment rate has gone up is this idea that there were all these construction workers in housing during the boom and that now that that housing bust has happened and we're never going to get back to the level of housing activity we saw in 2005-2006 that these construction workers are just going to be chronically unemployed.

And we've actually looked at what's happening to these construction workers, and we actually find that they're doing about as well as people in similar type of job categories in terms of finding new employment. So this idea that, you know, once you're a construction worker, you're always a construction worker, and if there's no construction, you're going to be unemployed for a very long period of time -- I just think the evidence doesn't really bear that out.

So I guess I would say we're on the -- maybe a little bit more on the optimistic end of the spectrum. But I don't think anybody thinks that, though -- you know -- you know, we can argue about whether the full employment rate if 5 percent or whether it's 5 1/2 percent or whether it's 6 percent. But I think that, you know, there's a very strong consensus that it's well below where we are today.

And the second thing I would just say on that is it's not as if the view I have today has to be absolutely accurate in terms of driving policy. You know, we are going to learn as we go. I mean, as we go forward, we're going to see how the labor market performs; we're going to see what happens to the labor participation rate; we're going to happen -- we're going to see what happens to labor compensation costs. And as we get all that information, I would imagine, you know, dynamically, we'll refine our estimates of what the full unemployment rate is.

CLARIDA: Right there. Steve.

QUESTIONER: Thanks. Steve Tananbaum, Golden Tree Asset Management. Looking at the negative real yields currently in the market, why do you think market participants are willing to accept negative real yields, and what do you think the implications are?

DUDLEY: Well, I don't -- I don't want to -- I don't want to put myself in the market participant's mind and say that I can necessarily think for market participants. I mean, obviously, the level of short-term interest rates are clearly a significant factor. The federal funds rate is trading at around 15 basis points. The inflation rate is running 2 percent. So we're setting very low real short-term interest rates. And to the extent that market participants expect that to, you know, persist for some time, that's going to be embodied further out the yield curve.

But what I think is interesting about the interest rate environment right now is not just that factor; there's also the factor that I alluded to in the speech, the fact that people expect real interest rates to be low not just today, but five to 10 years in the future. And I think that's a little bit more of a -- of a -- of a -- of a -- of a mystery. Maybe it reflects the fact that people think the economy is just going to require lower real rates to stay at the Fed's objectives of full employment and price stability.

QUESTIONER: It seems that on your graph on -- (inaudible) --

CLARIDA: One question -- (inaudible) -- thank you.

Right there. Yeah. Yes, you. Mmm hmm.

QUESTIONER: My name is Lucy Komisar, and I'm a journalist. And this also includes your capacity, as it says here, chairman of the Committee on Placement -- on Payment and Settlement Systems of the BIS from 2009 until this year. And it has to do with the issue of systemic risk. The dark pools through which the major prime brokers are dealing with their big customers have gotten to the point where it's reached 40 percent of the trades. And when they do the trading just internally, crossing internally within the particular prime broker and not between one and another, they don't -- not only don't they go through the DTCC, but they don't report to anybody, the SEC or anybody. And people have told me that they think that this is ripe for manipulation, and they call it a systemic risk. Do you think that's the case? Have you looked into this?

DUDLEY: Well, I've certainly looked into a lot of things as the chair -- the late chair of the CPSS, but I didn't -- I have not focused on that particular issue in any great detail.

The big project that the CPSS has been working on for the last three years -- I was the chair for about three years, and we just completed stage one of this process recently -- is to promulgate an updated set of principles for financial market infrastructures. And this is particularly important now because we're basically going to require financial market infrastructures to carry a lot more of the burden of financial stability going forward.

If you remember, the G30 ministers have agreed and heads of state have agreed that we want to have mandatory standardized -- mandatory clearing of standardized OTC derivatives trades through central counterparties at the end of 2012. So those central counterparties -- they have to be robust so that they don't fail under any set of circumstances. And so what the CPSS, working with IOSCO, has been up to is promulgating a set of financial market -- principles for financial market infrastructures that ensures that CCPs are bulletproof. This is very, very important. I think that, you know, the financial market -- (inaudible) -- is it has performed very well through the crisis. But we are requiring it to do quite a bit more going forward.

I think the important thing about the principles that I think is noteworthy is before we had a set of guidelines; they were recommendations. You know, you were -- you could follow them, or you could -- didn't have to follow them depending on the regulatory regime. The principles that have been endorsed by the G30 -- G-20 countries -- and as a consequence, these are now going to be the minimum standards around the world for systemically important financial market -- (inaudible). So I think it's a very, very important step.

Next question, right there, Frank.

QUESTIONER: Thank you. Frank Brosens, Taconic Capital. I'm -- right now there are no real signs of inflationary pressures that concern you, but I assume at some point there will be as the economy comes back. I'm just curious, with debt to GDP approaching a hundred percent, the impact of increasing rates -- obviously has an impact on the federal deficit. And I'm wondering how that affects the Fed's view of the timing of getting ahead of inflation by raising rates.

DUDLEY: Well, you're absolutely right, Frank. I actually gave a little talk on that a couple months ago, basically talking about how -- basically, I think, trying to send a little bit of a message to our government that debt service burdens today are extremely low because the Federal Reserve has a very low interest regime in place, and so the yield curve is very low as a -- as a consequence. But that should be viewed as temporary, not permanent, and so that debt service costs are going to go up significantly once policy becomes normalized, both because of higher debt, but also because of higher interest rates.

All I can say is that, you know, we're going to do what we have to do to achieve our dual-mandate objectives and that doing that in a timely way may drive up debt service costs. It probably will drive up debt service costs, and it will make the fiscal challenges a little bit more daunting. But that's not our problem. Our problem is to conduct monetary policy correctly to achieve the dual mandate.

CLARIDA: Right there.

QUESTIONER: Glen Lewy, Hudson Ventures.

CLARIDA: Stand up, please.

QUESTIONER: Sorry. What actions would you like to see happen with respect to the fiscal cliff? And do you expect that Fed policy will change significantly depending on which of the various outcomes may come as a consequence?

DUDLEY: Well, I'm totally not going to get into the specifics of, you know, what I'd pick from bucket A, bucket B or bucket C. I think we've been very clear about what we'd like to see. We'd like to see, you know, a policy of fiscal restraint that starts small and goes quite large over time, that's credible. So I think that implies that it's bipartisan, so you have the feeling that it's going to be built to last regardless of which political party happens to be in power at a particular period of time. That's really what's important to us on the -- on the fiscal side.

Now, you know, will the fiscal outcome have an implication for monetary policy? Yeah, potentially. There's a big difference between the fiscal cliff just being happening as it -- as it -- as it's on track today -- I mean, if nothing is done on the policy front and this all happens automatically, we'll have restraint of over 3 percent of GDP on January 1st -- starting January 1st, 2013. That will have pretty significant implications for the economic outlook, and we'll have to take those into consideration.

If something is done that dramatically changes that forecast, you know, in terms of what's going to happen on the fiscal side, of course we'll take that into consideration in how we think about monetary policy.

CLARIDA: I have a question now from a national member, Diane Swonk in Chicago. Diane asks you, Bill, quote, "Along with transparency comes a sense of seeing the sausage being made." (Laughter.) "What moves could or will the Fed make to clarify more than confuse as it reveals its policymaking process," end quote?

DUDLEY: Well, we have 19 members now, up from 17. (Laughter.) So there's lots of -- you know, lots of different views on the committee. And I think, you know, as Chairman Bernanke has said, that's probably a good thing, not a bad thing, in the sense that if -- you know, if there's just one person, one view, you really wouldn't get the full input of what's really going on in the -- in the national economy. But then the question is how do you communicate that in a -- in a -- in a clear way.

You know, I think the answer I would say is, you know, we're continuing to work on it. I would not view where we are today as our final resting place in terms of communication. We continue to make gradual steps to be -- to clarify our intentions. I mean, for example, the chairman's press conferences, putting in the interest projections in the Summary of Economic Projections, for example. So I think -- we think that we can continue to refine this.

And I would just want to reiterate something that the chairman has said in his press conference. At the end of the day if you're confused, pay attention to what the committee decides; that's really what matters. The committee decisions dominate the views of any one individual talking in the press.

Let's see, in the back of the room, right there in the green shirt. Yes.

QUESTIONER: I liked, Richard, your approach of saying let's look -- let's talk to the historians --

CLARIDA: Identify yourself, please.

QUESTIONER: Oh, I'm sorry. Rob Dieterich, Bloomberg Markets. Talking to the historians, you know, 50 years hence or whatever. So tell us, if you would, what happened after the Congress in 2013 took away the dual mandate in favor of just inflation.

DUDLEY: Well, that's a hypothetical. I mean, my view on this is --

QUESTIONER: It's over 50 years in the future, so -- .

DUDLEY: You know, I think at the end of the day, if that were to happen, you know, we're obviously going to do whatever Congress instructs us to do. It's in the Congress -- it's the prerogative of Congress to decide what is the appropriate mandate for the Fed.

My own personal opinion is that if we have a dual mandate or if we have single inflation objective, I personally don't think that would actually change monetary policy very much. And the reason for that is I think that price stability broadly defined is an absolutely critical precondition for achieving best outcomes in terms of employment. So I don't see the two goals in, you know, major conflict to one another. So I don't think it would actually change policy very much.

CLARIDA: Right there in the white shirt. Yes.

QUESTIONER: Thank you. My name is Roland Paul. I'm a lawyer. Unemployment is enormously high, and long-term unemployment is historically unique, whereas inflation rate is pretty stable, as you pointed out. There are economists -- I think I'm correct in mentioning that Paul Krugman and people like that say the Fed should doing a lot more than it is doing to relieve this horrendous unemployment situation, though you seem reluctant to do that, in your remarks. But I'd welcome any insights you'd give us.

DUDLEY: Well, as I said in my remarks, I mean, tools have benefits but they also have costs. And I think what -- you know, the debate you hear on monetary policy is exactly where those two lines intersect. You know, as you do more, the benefits curve -- the benefit curve comes downward; as you do more, the cost curve goes upward; and so they intersect at some point.

So I think there's a complete agreement that we want to go all the way out to the point where those two lines intersect, but different people have disagreements about where those lines intersect. So it's -- you know, I think it's ultimately a bit of a judgment call in terms of what the costs are and the benefits are of additional policy accommodation.

QUESTIONER: (Off mic.)

DUDLEY: No, I mean it's -- you know, there's costs in a lot of different ways. I mean, the cost is, you know, the effectiveness of the policy. The cost is potential anxiety about the interest rate risk the Federal Reserve might be potentially taking on its balance sheet. Cost could be anxiety that the Fed's actions are potentially, you know, sowing the seeds for a future inflation problem, and some people might see (that as a ?) a risk. If people think that's a risk, then that's a potential cost.

So, you know, these are all judgments that people make, and so there's -- people are going to disagree about where -- I mean, I would be surprised if there wasn't a lot of disagreement at a point where these lines are crossing, because people are going to disagree about, oh, we should do a little bit more or we did a little bit too much. I think this is exactly what you should expect in the current set of circumstances.

CLARIDA: Right there. Yes, sir, in the middle table.

QUESTIONER: I'm Jay Goldin. Could you elaborate a bit on what your view is respecting the potential impact of developments in Europe on the United States?

DUDLEY: No. (Laughter.) Seriously, you know, it's obviously a very difficult situation when you have 17 countries trying to work their way towards, I think -- you know, towards greater fiscal and economic integration. If you remember, in the United States we had trouble, one country, passing the TARP legislation. So I think we should not understate, you know, the political complexity of what they're trying to accomplish.

I think the good news is that -- my sense is that the European leadership very much is committed to the eurozone and the European Union. I think as we've seen throughout the last few years, that when push comes to shove, we're gradually moving in the direction of greater integration. And, you know, I hope that continues.

CLARIDA: Another question from a national member, actually international member. Richard Portes of the London Business School says, quote: What is the Federal Reserve's assessment of the international repercussions of quantitative easing? Are you concerned about the currency wars interpretation, and do you take this into account when you set policy?

DUDLEY: Well, I think that when we did the -- what was called QE2, I think there was quite a bit of reaction in emerging market quarters. I think it was partly on the basis of a misunderstanding of what were trying to accomplish.

My own view is that an early economic recovery by the United States is not just in the United States' interest but is probably good for the global economy. And, you know, QE2 was in no way designed to start currency wars. That really had nothing to do with that program. QE2 was designed to provide a more accommodative U.S. monetary policy and push the U.S. economy faster back towards -- towards full employment.

CLARIDA: I think we have time for one or two more. Let's see, right there.

QUESTIONER: Thank you. Tom Hill, Blackstone. You referenced in your remarks about the liquidity trap in Japan. What were the lessons learned as applied to the U.S.?

DUDLEY: Well, there was actually a very interesting Federal Reserve staff paper that was done a number of years ago that went back and analyzed the Japanese experience. And what they found was that the Japanese really didn't behave badly given the information they had at the time. But the lesson of the paper was that they just underestimated, you know, the degree of headwinds and how difficult it would be to sort of catch up on the policy front.

So the conclusion of the paper was, with the benefit of hindsight -- and this is with the benefit of hindsight, it wasn't really a criticism of the Japanese authorities -- the lesson is that you want to be more aggressive. And I think if you sort of look at what the U.S. has done in the aftermath of the financial crisis, I think we took onboard the lessons of Japan and were more aggressive on both the monetary policy front and on the fiscal policy front.

CLARIDA: Let's see. Right there, the blue tie.

QUESTIONER: Sean Fieler with Equinox Partners. President Dudley, I think you're right to be concerned about legislation that would impose a rule on the Federal Reserve. And you clearly articulated your opposition to the formal imposition of the Taylor rule. But if you had to live with a rule, would that be your favorite rule to live with or is there something else that you would rather live with? (Laughter.)

DUDLEY: Well, I'm not going to endorse any particular rule, because that's not really how I think about monetary policy. I really think about monetary policy in a little bit different way, which is, you know, what policy setting will achieve the best trajectory back to our objectives. So you can think of that as more of a forecast-oriented targeting rather than an instrument-based targeting, which is a Taylor rule kind of formulation. So I don't really think of it in Taylor rule terms very much. But since people debate about Taylor rule all the time, I thought I would take my views and sort of recast them in Taylor rule terms.

You know, as I said in my remarks, I mean, I think the Taylor rule flexibly applied actually, you know, can work reasonably well, but I think as my remarks also made clear, flexibly applying the Taylor rule is actually pretty difficult because you have to make a lot of judgments about, you know, what's the balance-sheet effect of the Fed's action, how does that translate into interest rates, how you take into consideration (symmetric/asymmetric ?) risk, how you take into consideration changes in the equilibrium real rate of interest. And so, you know, if you're doing all that, do you still have a rule or do you have something that's really more subtle than that?

CLARIDA: I think on that note, I think we will conclude the session. Bill, thank you very much.

And we are adjourned.

DUDLEY: Thank you. (Applause.)

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