the economy is likely to be negative, in large part because borrowers typically and if the increase that service burdens and decline in collateral values are severe push borrowers into bankruptcy then the resulting hardship imposed on families, small business owners and laid-off workers may be very severe. earlier, after weighing the costs associated with various rates of inflation, the fomc decided that 2% inflation is an appropriate operational definition of its longer run price objectives. in the wake of the 2008 financial crisis, however, achieving both this objective the othermployment,

leg of the federal reserve's dual mandate has been difficult. ,nitially the unemployment rate the solid black line, sword, and inflation fell sharply. moreover after the recession officially ended in 2009, the subsequent recovery was significantly slowed by a headwinds,persistent including households with underwater mortgages and high debt burdens, reduced access to credit for many potential borrowers, constrained spending by state and local governments, and weakened foreign growth prospects. in an effort to return to employment and inflation to levels consistent with the federal reserve's dual mandate, took a variety of

unprecedented actions to lower long-term interest rates. including reducing the federal funds rate, that is the dotted black line, to near zero, communicating to the public that short-term interest rates would likely stay exceptionally low for some time, and buying large quantities of longer-term treasury debt and agency issued mortgage-backed securities. these actions contributed to highly accommodative financial conditions, thereby helping to bring about the considerable improvement in labor market conditions over time. the unemployment rate which peaked at 10% in 2009 is now 5.1%. that's slightly above the median currentparticipants estimates of its longer run normal level. although other indicators

suggest that the unemployment rate currently understates how much slack remains in the labor market, on balance the economy is no longer far away from full employment. inflation has continued to run below the committee's objective over the past several years. months, it has2 been essentially zero. nevertheless, the committee expects that inflation will gradually return to 2% over the next two or three years. turn to the to now determinants of inflation and the factors that underlie this expectation. andls used to describe predict inflation commonly distinguish between changes in food and energy prices which

enter total inflation and movements in the prices of other goods and services. that is called core inflation. this is useful because food and energy prices can be extremely volatile, with fluctuations that often depend on actors beyond the influence of monetary policy. such as technological or political developments in the ore of energy prices, whether or disease in the case of food price. providesation usually better indicators that total of where total inflation is headed in that medium term. of food and energy accounts for a significant portion of household budgets. the federal reserve's inflation objective is defined in terms of the overall change in consumer prices. what been determined score inflation?

recalling figure one, core inflation tends to fluctuate thatd a longer-term trend now is essentially stable. let me first focus on these fluctuations and then turned to the trend. economic theory suggests an empirical analysis confirms that deviations of inflation from trends depend partly on the intensity of resource utilization in the economy. as approximated for example by the gap between the actual unemployment rate and the so-called natural rate, or by the shortfall of actual gross thomistic product or gdp for potential output. , which likelyhip reflects among other things a tendency for firms cost to rise

as utilization rates decrease. this represents an important channel through which monetary policy influences and nation over the medium-term. although in practice the influence is modest and gradual. movements in certain types of input costs, particularly changes in the price of imported good, also can cause core to deviate noticeably from its trend. sometimes by a marked amount from year-to-year. a nontrivial fraction of the quarter to quarter and even the year-to-year, variability of inflation is attributable to idiosyncratic and often unpredictable shocks. what about the determinants of inflation's longer-term trends? it is constructive to compare

estimatey statistical of the trend rate of future inflation that i showed you in my first figure. actualeasures people's expectations of long-run inflation, which is what you see in this figure. here it suggests that inflation expectations which presumably are linked to the central banks inflation goals, should play an important role in actual price setting. indeed the contours of the series are strikingly similar. it suggests that the estimated trend in inflation is in fact related to households and firms long-run inflation expectations. so to summarize, this analysis suggests that economic slack changes in imported goods prices and idiosyncratic shocks all

cause core inflation to deviate from a longer run trend that is ultimately determined by long-running inflation expectations. as some of you may recognize this model of core inflation is a variant of a theoretical model that is commonly referred to as an expectations augmented phillips curve. total inflation reflects inflationin core combined with changes in the prices of food and energy. important feature of this model of inflation dynamics is that the overall effect with variations in resource utilization, import prices and other factors will have on inflation depends crucially on whether these influences also affect long-run inflation expectations. this figure illustrates this

point with the stylized example of the inflation consequences of a gradual increase in the level of import prices. perhaps occurring in response to stronger real activity abroad or following the extreme -- exchange value of the dollar. andauses the rate of change import prices to be elevated for a time. first consider the situation shown in panel a comment which household confirms expectations of inflation are not solidly anchored, but instead in response to the rates of inflation that are actually observed. which arguably prevailed in the united states from the 1970's to the mid-1990's could plausibly arise has in theral bank

past allowed significant and persistent movements in inflation to occur. the temporary rise in the rate of change of import prices results in a permanent increase in inflation. because thecurs initial increase in inflation of risingby a period import prices causes households and concerns to raise their expectation of future inflation. it would result from a sustained rise in the level of oil prices or a temporary increase in resource utilization. contrast, supposed that inflation expectations are instead well anchored. perhaps because the central bank has been successful over time in keeping inflation near some specified target and has made it

clear to the public that it intends to continue to do so. then the response of an flechette -- of inflation or any other transitory shop will resemble a pattern shown in panel b. in this case inflation will deviate from the longer-term trend only as long as import prices are rising. but once they level out, inflation will fall back to its previous trend in the absence of other disturbances. the key implication of these two examples is that the presence of well anchored inflation expectations greatly enhances the central bank possibility to -- the central bank's ability.

other transitory shop cap note permanent influence on expectation, they have only a transitory effect on inflation. the result is that a central such shortok through run inflationary disturbances in setting monetary policy, allowing it to focus on returning the economy to full placing pricehout stability at risk. and indeed, the federal reserve has done exactly that in setting monetary policy over the past decade or more. moreover, as i will discuss shortly, these inflation dynamics are a key reason why the fomc expects inflation to return to 2% over the next few years. balance, the evidence suggests that inflation

expectations are in fact well anchored at present. two figure plots the serving measures of long-term expected inflation i presented earlier, along with the measure of longer-term inflation compensation that derive the difference on yields in nominal treasury securities and calledon index once tips. since the late 1990's, serving measures of long-term inflation expectations have been quite stable. has persisted in recent years, despite the deep recession and concerns expressed by some observers regarding the potential inflationary effects of unconventional monetary policy.

the fact that these survey measures appear to have remained anchored at about the same levels that prevailed prior to the recession suggests that once the economy is returned to full employment and absent any other shocks, core inflation should return to its pre-recession average level of about 2%. the conclusion is tempered somewhat by recent movements in longer run inflation compensation. which in principle could reflect changes in investors expectations for long-run and nation. this measure is now noticeably lower than in years just prior to the financial crisis. however, movements in inflation compensation are difficult to interpret, because they can be driven by factors that are unique to financial markets, ,uch as movements in liquidity

missed premiums, as well as by changes in expected inflation. indeed, empirical work that attempts to control for these factors suggest that the long-run inflation expectations embedded in asset prices have in fact moved down relatively little over the past decade. nevertheless, the decline in inflation compensation, that is the red line, over the past year, may indicate that financial market participants now see an increased risk of inflation. the evidence on balance suggests that inflation expectations are well anchored in the present, policymakers would be unwise to take the situation for granted. anchored inflation expectations were not gained easily or quickly. experience suggests that takes

many years of carefully conducting monetary policy to alter what households and firms perceived to be inflation's normal behavior. furthermore the persistent failure to keep inflation under control by letting it drift either too high or too low for too long could cause expectations to once again become unmoral. given that inflation has been objectivelow the fomc for several years now, such concerns reinforce the appropriateness of the federal reserve's current monetary policy which remains highly accommodative by historical standards and is directed towards helping return inflation to 2% over the medium-term. before turning to the implications of the situation model to the current outlook and

monetary policy, i do think a cautionary note is in order. the phillips curve approach to forecasting inflation has a long and hasin economics usually informed monetary decision-making around the globe. but the theoretical underpinnings of the model are still subject of controversy among economists. moreover, inflation sometimes moves away from empirical versions of the model which necessarily are a simplified version of the complicated reality cannot adequately explain. for this reason, significant uncertainty attaches to phillips curve predictions and the validity of forecasts from this model do have to be continuously evaluated in response to incoming data.

but assuming that my reading of the data is correct and long-run inflation expectations are in fact anchored near the prerecession levels, what implications does the preceding description of inflation dynamics have for the inflation outlook and for monetary policy? firstramework suggests that much of the recent shortfall of inflation from our 2% objective is attributable to special factors whose effects are likely to prove transitory. as the solid black line in pcere eight indicates, inflation has run noticeably below the 2% objective on average since 2008 with a short ball approaching about a percentage point in both 2013 -- 2014 and more than 1.5%

percentage points this year. the stacked bars in the figure give the contributions for various factors to these deviations from 2%. they are computed using an estimated version of the simple inflation model i just discussed. as the solid blue portion of the bar shows, falling consumer energy prices explain about half of this year's shortfall and a sizable portion of the 2013 and 2014 shortfalls as well. another important source of downward pressure this year has been the decline in import prices. the portion with orange , which isrd pattern largely attributable to the 15% appreciation in the dollar's

exchange value in the pasture. in contrast, the restraint hassed by economic slack diminished steadily over time as the economy has recovered and is now estimated to be relatively modest. finally, the similarly small portion of the current shortfall of inflation from 2% is explained by other factors which include changes in food prices. importantly, the effects of these other factors are transitory and often switch sides from year-to-year. although an accounting exercise like this one is always imprecise and will depend on the specific model that is used, i think it is -- it's basic message that the current near zero rate of inflation can mostly be attributed to the temporary effects of falling prices for energy and not energy

imports is quite plausible. if so, the 12 months change in prices is likely to rebound to 1.5% or higher next year, barring of further substantial drop in crude oil thees and provided that dollar does not appreciate noticeably further. reasonably confident that inflation will return to 2% over the next few years, we need in turn to be reasonably confident that we will see continued solid economic growth and further gains in resource utilization with longer-term inflation remaining near their prerecession level. fortunately, prospects for the u.s. economy generally appear solid. monthly payroll gains have

averaged close to 210,000 since the start of the year and the overall economy has been expanding modestly faster than its productive potential. my colleagues and i, based on our most recent forecast, anticipate that this pattern laborontinue and that market conditions will improve further as we head into 2016. the labor market has achieved considerable progress over the past several years. improvement inr labor market conditions we can we are probably not yet all the way back to full employment. although the unemployment rate may now be closer to its longer run normal level, which most fomc participants now estimate

is around 4.9%, this traditional metric of resource utilization almost certainly understates the actual amount of slack that currently exists. basis,clically adjusted the labor force participation rate remains low relative to the underlying trend and an unusually large number of people are working part-time but would prefer full-time employment. consistent with this assessment is the slow pace at which hourly wages in compensation have been rising. which suggests that most firms still find it relatively easy to hire and retain employees. reducing slack along this other dimension may involve a temporary decline in the unemployment rate somewhat below the levels it is estimated to be consistent in the longer run

ath deflation stabilizing 2%. for example, attracting discouraged workers back into the labor force may require a iod of especially plentiful employment opportunities and strong hiring. similarly, firms may be unwilling to restructure their operations to use more full-time workers until they encounter greater difficulty filling part-time positions. considerations, a modest decline in the unemployment rate below its wouldun level for a time by increasing resource utilization also have the benefit of speeding the return to 2% inflation. finally, albeit more speculatively, such an environment might help reverse some of the significant supply side damage that appears to have occurred in recent years,

thereby improving the american standard of living. consistent with the inflation way mark i have outlined, the medians of the projections provided by fomc participants at our recent meeting show inflation gradually moving back by a, accompanied temporary decline in unemployment slightly below the median estimate of the rate expected to prevail in the longer run. these projections embody two key judgments regarding the projected relationship between real activity and interest rates. first, the real federal funds rate is currently somewhat below the level that would be real gdpt with expanding in line with potential. this implies that the

unemployment rate is likely to continue to fall in the absence of some tightening. participants implicitly expect that the headwinds for economic growth that i mentioned ,arlier would continue to say thereby boosting the economy's underlying strength, combined these judgments apply -- imply that the real interest rate consistent with achieving and then maintaining unemployment in the medium run should gradually rise over time. this expectation, coupled with inherent lags in the response of real activity and inflation to areges in monetary policy the key reasons that most of my colleagues and i anticipate that

it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves that to our 2% objective. timing of the precise the first increase in our target of the federal funds rate should have only minor implications for financial conditions in the general economy. what matters for overall financial conditions is the entire trajectory of short-term interest rates anticipated by markets and the public. as i noted, most my colleagues economicicipate that conditions are likely to warrant raising short-term interest rate at a quite gradual pace over the next few years. to emphasize,t

however, that both the timing of the first wave increase and any subsequent adjustments to our federal funds rate target will depend on how developments in the economy influence the committee's outlook for progress toward maximum employment and 2% inflation. the economic outlook of course is highly uncertain and it is conceivable, for example, that inflation could remain appreciably below are 2% target, despite the apparent anchoring of inflation expectations. history may recent be instructive. this figure shows that survey measures of longer-term expected inflation in japan remain positive and stable even as that country experienced many years of persistent mild deflation.

explanation for the persisting divergence between actual and expected inflation in japan is not clear. but i believe it illustrates a problem faced by all central banks. economist understanding of the dynamics of inflation is far from perfect. reflecting that limited understanding, the predictions of our models often air sometimes significantly so. accordingly, inflation may rise more slowly or rapidly then the committee anticipates and if such a development of occurs, would of course need to adjust in stance of policy response. considerable uncertainties also surround the outlook for economic activity. for example, we cannot be certain about the pace at which the headwinds will continue to

fade. , exports serve as a significant drag and financial develops highlight the risk that a slowdown of foreign growth might restrain u.s. economic activity somewhat further. the committee is monitoring developments abroad, but we do not currently anticipate that the effects of these recent developments on the u.s. economy improved be large enough to have policy.icant effect on that said, in response to sip prizes affecting the outlook for economic activity, as with those affecting inflation, the fomc would need to adjust the stance of policy so that her actions remain consistent with inflation