Credit was eased when the economy weakened and tightened when inflation threatened, but largely in an ad hoc manner. As a consequence, the Federal Reserve was perceived by some as often accentuating, rather than damping, cycles in prices and activity.

Subsequently, however, the experience of stagflation in the 1970s and intellectual advances in understanding the importance of expectations--which built on the earlier work of Friedman and Phelps--undermined the notion of a long-run tradeoff. Inflation again became widely viewed as being detrimental to financial stability and macroeconomic performance. And as the decade progressed, a keener appreciation for the monetary roots of inflation emerged both in the profession at large and at central banks.

At various points in time, some analysts have held out hope that a single indicator variable--such as commodity prices, the yield curve, nominal income, and of course, the monetary aggregates--could be used to reliably guide the conduct of monetary policy. If it were the case that an indicator variable or a relatively simple equation could extract the essence of key economic relationships from an exceedingly complex and dynamic real world, then broader issues of economic causality could be set aside, and the tools of policy could be directed at fostering a path for this variable consistent with the attainment of the ultimate policy objective.

M1 was the focus of policy for a brief period in the late 1970s and early 1980s. That episode proved key to breaking the inflation spiral that had developed over the 1970s, but policymakers soon came to question the viability over the longer haul of targeting the monetary aggregates. The relationships of the monetary aggregates to income and prices were eroded significantly over the course of the 1980s and into the early 1990s by financial deregulation, innovation, and globalization. For example, the previously stable relationship of M2 to nominal gross domestic product and the opportunity cost of holding M2 deposits underwent a major structural shift in the early 1990s because of the increasing prevalence of competing forms of intermediation and financial instruments.

In effect, we strive to construct a spectrum of forecasts from which, at least conceptually, specific policy action is determined through the tradeoffs implied by a loss-function. In the summer of 2003, for example, the Federal Open Market Committee viewed as very small the probability that the then-gradual decline in inflation would accelerate into a more consequential deflation. But because the implications for the economy were so dire should that scenario play out, we chose to counter it with unusually low interest rates.

The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario. Moreover, the risk of a sizable jump in inflation seemed limited at the time, largely because increased productivity growth was resulting in only modest advances in unit labor costs and because heightened competition, driven by globalization, was limiting employers’ ability to pass through those cost increases into prices. Given the potentially severe consequences of deflation, the expected benefits of the unusual policy action were judged to outweigh its expected costs.

The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes.

The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.

Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

I acknowledge that monetary policy itself has been an important contributor to the decline in inflation and inflation expectations over the past quarter-century. Indeed, the Federal Reserve under Paul Volcker’s leadership starting in 1979 did the very heavy lifting against inflation. The major contribution of the Federal Reserve to fashioning the events of the past decade or so, I believe, was to recognize that the U.S. and global economies were evolving in profound ways and to calibrate inflation-containing policies to gain most effectively from those changes.