Over the past three decades, we have experienced an increased number of financial crises in many countries around the world. These crises have taken place in many different parts of the financial system, including: banking and payments systems, housing finance systems, securities markets, and currency markets. Central banks and other authorities charged with maintaining financial stability have drawn important lessons from each of these crises and have instituted regulatory and policy changes that have helped strengthen the financial system in the wake of these crises.

Despite our best efforts, financial crises have continued to return in modified form, requiring ongoing vigilance. Moreover, the task of maintaining financial stability has become more difficult over time because of the changing structure of the financial system. Unfortunately, we have not adapted our regulatory and policy framework at the same speed as financial market developments.

In a speech made before the High Level Meeting on Regulatory Capital and Issues in Financial Stability in Sydney, Australia, last November, Mr. Hoenig used the recent subprime mortgage crisis to motivate a broader discussion of how we can maintain financial stability in a changing financial system. While the recent crisis has revealed some new and unexpected vulnerabilities in the financial system, it has also highlighted the need to remember some of the lessons we have learned from past crises.

Has the Behavior of Inflation and Long-Term Inflation Expectations Changed? (PDF 1,024K)
By Todd E. Clark and Taisuke Nakata

From 1975 to 1980, inflation in core (nonfood and nonenergy) consumer prices rose sharply as crude oil prices more than tripled. Yet, as crude oil prices quadrupled from late 2001 to 2007, core consumer price inflation remained essentially flat. Some observers have attributed the stability of consumer price inflation in the more recent episode to the influence of long-term inflation expectations. While inflation expectations rose significantly in the second half of the 1970s, they remained largely unchanged from 2001 through 2007. The increased stability of inflation and long-term expectations raises the possibility that the behavior of both variables has fundamentally changed.

Recent discussion has focused on two possible forms of change: the influence of long-run expectations on inflation and the anchoring of inflation and expectations. A third possible source of change is smaller shocks to inflation, expectations, and other macroeconomic variables. Any of these changes in the behavior of inflation and long-term inflation expectations could have important implications for monetary policy.

Clark and Nakata find some evidence that the dynamics of inflation and long-term inflation expectations have changed modestly. In particular, compared to 20 or more years ago, inflation and expectations appear to be slightly better anchored: Unexpected increases in inflation die out slightly faster and produce less of an increase in long-term expectations. However, the reduced volatility of inflation and expectations is largely due to smaller shocks.

PCE and CPI Inflation Differentials: Converting Inflation Forecasts? (PDF 506K)
By Craig S. Hakkio

The Federal Reserve recently announced it will begin to release quarterly inflation forecasts based on the Personal Consumption Expenditure Price Index. As Chairman Bernanke said, the PCE index is generally thought to be ?the single most comprehensive and theoretically compelling measure of consumer prices.? At the same time, Bernanke said that ?no single measure of inflation is perfect, and the Committee will continue to monitor a range of measures when forming its view about inflation prospects,? including the Consumer Price Index.

The public and private sectors alike will want to be able to convert CPI inflation forecasts released by various organizations to PCE inflation forecasts, and vice versa. But the inflation differentials for the two measures can change significantly over time. To convert between CPI and PCE inflation projections, economists must construct statistical models to explain and predict the inflation differentials (overall and core), recognizing that the differentials may change over time.

Hakkio estimates a set of models that analysts can use to make such conversions.

Will Rural Prosperity Prevail in 2008? (PDF 556K)
By Jason Henderson and Maria Akers

The rural economy was strong in 2007. Record farm incomes were fueled by rising ethanol demand and by stronger export demand, which was driven in part by a weaker dollar. Farmers used the year’s higher profits both to strengthen their financial conditions and to boost investment in land and equipment. Meanwhile, businesses on Main Streets reaped benefits from the higher farm spending, and the fortunes of energy-dependent regions brightened with higher energy prices.

As the year progressed, however, the outlook for the rural economy began to dim. Following national trends near the end of the year, Main Street activity waned. The higher costs for gas and heating fuel pinched rural household budgets. And, despite robust outlooks for ethanol production and exports, rising energy costs began to trim profit margins for farm and nonfarm businesses alike.

Henderson and Akers review the state of the rural economy in 2007 and discuss its prospects for 2008.