The role of monetary policy is to ensure the stability of the purchasing power of the nation’s currency so that markets are not distorted by inflation.
Taking expected inflation into account, the level of the federal funds rate in real terms — what economists call the real rate of interest — is now negative. The last time the level of real interest rates was this low was in 2003-2004. But that was a different time with a different concern — deflation — and monetary policy was intentionally seeking to prevent prices from falling. Recently, we have had reason to be worried about rising inflation, not declining prices. Thus, comparing the nominal funds rate today with the stance of policy in 2003–2004 is like comparing apples and oranges.
We must keep in mind that monetary policy works with a lag. The full impact of changes in monetary policy on output and employment may not materialize for several quarters at the earliest. This lagged response means that monetary policy decisions depend critically on the outlook for the economy over the intermediate term. In times of economic turbulence and uncertainty, forecasting becomes more difficult. That does not mean that you can stop forecasting, but it does mean that the uncertainty surrounding any forecast will be unusually large.
Monetary policy cannot solve all the problems the economy and financial system now face. It cannot solve the bad debt problems in the mortgage market. It cannot re-price the risks of securities backed by subprime loans. It cannot solve the problems faced by those financial firms at risk of being given lower ratings by rating agencies because some of their assets are now worth much less than previously thought. The markets will have to solve these problems, as indeed they will. But it will take some time.
I love that part about how forecasting is more difficult in times of turbulence and uncertainty. If the Fed is to be effective it is exactly during those times when it is most critical to forecast accurately. Which is why Central Banking is ultimately a losing game.
At least Plosser understands the purpose of the Fed. That opening sentence is the most encouraging thing I've heard from a US central banker in a long time. He also acknowledges that monetary policy can't fix all problems. I would argue that monetary policy is the source of more problems than it can solve, but this is a start anyway.