by Calculated Risk on 2/13/2012 10:37:00 PM

From San Francisco Fed President John Williams: The Federal Reserve’s Mandate and Best Practice Monetary Policy. Excerpt:

What does this tell us about where monetary policy should be now? Inflation in 2012 and 2013 is likely to come in around 1½ percent, below the FOMC’s 2 percent target. And clearly, with unemployment at 8.3 percent, we are very far from maximum employment. At the San Francisco Fed, our forecast is that the unemployment rate will remain well over 7 percent for several more years.

This is a situation in which there’s no conflict between maximum employment and price stability. With regard to both of the Fed’s mandates, it’s vital that we keep the monetary policy throttle wide open. This will help lower unemployment and raise inflation back toward levels consistent with our mandates. And we want to do so quickly to minimize total economic damage. The longer we miss our objectives, the larger the cumulative loss to the economy.

QE3 is coming.

Williams also provides an excellent discussion on "price stability":

What objective should we seek for the rate of increase of average prices? Should we strive for no change at all, that is, zero inflation? At first blush, that seems sensible. But, there are a number of reasons why aiming for zero inflation would be too low and inconsistent with our maximum employment mandate. Here I’ll mention two.

First, a small amount of inflation can help grease the wheels of the labor market. There is considerable evidence that nominal wages don’t easily fall even when demand is weak, something economists call downward wage rigidity. In other words, it’s unusual for workers to have the dollar value of their wages reduced. In this regard, wages are very different from, say, airline ticket prices, which are quickly discounted when seats can’t be filled. Weak labor demand may necessitate a reduction in real wages, that is, wages adjusted for inflation. Even if the nominal, or dollar value, of wages won’t budge, the real wage will fall as prices rise. As a result, a little bit of inflation can help the labor market adjust to negative shocks and, in this way, help keep employment closer to its maximum level.

Second, a small amount of inflation gives the Fed a little more maneuvering room to respond to negative shocks to the economy. The problem is that nominal interest rates can’t go below zero. Economists refer to that limit as the zero lower bound. Let me define terms. The nominal interest rate can be divided into its two components: the real, or inflation-adjusted, interest rate; and expected inflation. A little bit of inflation tends to raise nominal rates on average in order to provide a positive yield to investors. That gives the Fed more room to lower interest rates in a recession before hitting the zero lower bound.