Q: How concerned are you by the upward spike in inflation so far this year?
A: Everybody agrees that the inflation environment has changed in the last year. I wasn't one of those a year ago who thought deflation had much probability to it. But some people did. Those fears are now gone.
The probability that we will see inflation a half-point higher than the best guess currently is higher than [that] we would see inflation a half-point lower. There's an asymmetry [that has] developed in the picture.... My own personal belief is that it's very important that we not allow an inflation process to get going. It tends to develop some momentum of its own, and it's expensive to reverse.
Q: Given the shift in inflation risks, can the central bank's policymaking Federal Open Market Committee (FOMC) continue to say it believes it can raise interest rates in a "measured" fashion?
A: You're asking a really loaded question. The FOMC has a meeting coming up [on June 29-30]. I'm not going to prejudge where we come out.
Q: Fed officials have talked about raising interest rates to a more neutral level. What level of rates constitutes neutrality?
A: The real [inflation-adjusted] rate of interest that will clear the markets changes over time. I don't want to say it cycles up and down. But it fluctuates. Over a long period of time, it comes out as some average. But that average...provides essentially no guidance whatsoever to [what to do with] short-run monetary policy.
What we need to do is to make sure that we raise the federal funds rate rapidly enough that you don't run the risk that the real rate of interest will fall even though the nominal rate is rising.
Q: Is there a danger of that happening now?
A: You always have to frame this question in terms of inflation expectations. What's past is past. To try to understand the effects of the recent increase in the rate of inflation on inflation expectations is an important part of this policy management we face.
Q: So what's happening with inflation expectations?
A: The longer-run expectations haven't changed. But near-term expectations of inflation have gone up somewhat over the last six months. How much of that is likely to carry forward is the analytical problem we face. The near-term inflation-expectations data need to be interpreted cautiously. A lot of that [rise] is a consequence of energy prices.
Now, I'm not trying to downplay the importance of energy. I think energy is important. We've seen a significant change in the last year or two. If you take five-year distant crude-oil futures, those futures used to trade in the $20 to $22 [per barrel] range. Now, it's up to $29 or even $30.
The five-year outlook for energy prices has moved up quite a bit. For that reason, I don't think we should focus entirely on a core price measure [of inflation] that completely strips out energy. What I would like to do is strip out the short-term [movements in energy prices] but keep the longer-run [movements] in there because that's affecting the fundamentals we have to deal with.
That's the sort of horizon where monetary policy really makes a difference. We can't do much about the quarterly or even annual fluctuations [in inflation], but over five years that's our responsibility. We shouldn't ignore the role of those longer-run developments in the energy market.
Q: What, in your view, constitutes price stability?
A: My own personal goal for inflation is zero, properly measured [after taking out the distortions in the price indexes]. We never got there. I don't think we got there last year either. We were a little above that.
But I don't think that my view is the consensus view within the FOMC. What I think is much more important than quibbling over a few tenths or maybe a percentage point of inflation is the commitment to staying in this neighborhood. And I regard that as far more important than a precise definition of what that number could be.
Q: You've been very critical of mortgage companies Fannie Mae and Freddie Mac. What worries you about them?
A: I believe that Fannie and Freddie expose the economy to a systemic risk [by borrowing short to lend long]. I don't regard the probability [of them disrupting the financial system] as being very high, but I regard the probability as being high enough.
If you multiply the probability times the damage that would result, you get a pretty big number. It's precisely because the consequences would be so severe that I believe that low probability is worth paying attention to and worth fixing.
I'm also concerned that, whatever may be the probability today, I would hate to see that probability rise. And I fear that it could because the capital positions [of Fannie and Freddie] are thin, and because these two firms have very aggressive growth objectives. Therefore, the problem is going to be larger going forward.