##emptive if it responds to incoming data on utilization rates, given the link between current utilization rates and future inflation. of course, the degree of confidence that policymakers have in this link ( and specifically in their measure of excess demand ) will determine how preemptive they are prepared to be. the greater uncertainty about the level of excess demand should, i believe, diminish the aggressiveness with which monetary policy responds to changes in utilization rates. the difficulty in forecasting should, in addition, encourage more emphasis on responding to incoming data and diminish ( though not eliminate ) the role of the forecast in the policy decision. this is sensible and prudent. to sever this relationship of monetary policy either to incoming data on utilization rates or to the forecast altogether, however, would remove the key elements of preemptive monetary policy with respect to containing inflation and leave policy entirely reactive. if the uncertainty were great enough, this would be a reasonable response. but i do not believe that such an extreme position is warranted. there are, however, a couple of constructive policy responses in light of prevailing uncertainties about the level of excess demand and the forecast. first, policymakers could update their estimates of the nairu and the output gap ( assuming, in the first place, that they find these concepts useful, as i do ) in light of realizations of unemployment, output, inflation and other variables. this has, in fact, been one response that many, including myself, have taken in response to recent developments. in following this approach, policymakers would become less responsive to declines in the unemployment rate, to the extent that estimates of the nairu are revised downward as unemployment and inflation decline together. second, policymakers could attenuate the response of the real federal funds rate to declines in the unemployment rate in a region around their estimate of the nairu. but once the unemployment rate gets far enough below ( or above ) the estimated nairu so that confidence returns that the labor market is experiencing excess demand ( or supply ), then the more normal response of real interest rates to incremental declines in the unemployment rate would again become appropriate. but you have to be careful about overdoing caution as well as overdoing aggressiveness. if you take care to adjust your estimate of the nairu and the output gap in response to incoming data, you would be unwise to ignore these revised measures of the unemployment and output gaps in setting policy. 2. what

implications for monetary policy of a step - up in trend productivity growth and, hence, trend real gdp growth? first, such a development would ultimately call for an upward revision to the targets for money growth, so that the money growth targets would remain consistent with an unchanged target for the inflation rate. as a practical matter, however, this is not a serious policy issue because the monetary aggregate targets play only a minor role in the conduct of monetary policy today. at any rate, such an adjustment might be premature today, given the uncertainty about the underlying trend. however, if the apparent higher trend productivity and gdp growth persists, at some point the money growth ranges should be appropriately adjusted. under the prevailing operational regime of setting a target for the federal funds rate, money growth would automatically adjust to accommodate the higher rate of trend growth, at an unchanged nominal federal funds rate target. over the longer run, the challenge under an interest - rate regime is to align the real federal funds rate with its new equilibrium value, which is likely to increase with a higher trend rate of productivity growth ( due to a higher return on capital that underlies the new equilibrium real interest rate in the economy ). the principal challenge to a monetary policy focused on utilization rates is that an unexpected shift in productivity growth, in effect lowers the unemployment rate consistent with stable inflation ( the nairu ) for a while. this allows the economy to operate at a higher utilization rate without inflationary consequences, at least until the higher productivity is fully anticipated in wage bargaining or until productivity growth stops accelerating. let me explain the source of the decline in the effective nairu. assume that the increase in productivity is not anticipated and therefore does not immediately raise workers ’ real wage demands. with unchanged nominal wage demands and higher productivity, firms will experience a decline in unit labor costs. this will initially boost profits. but competition will quickly force the lower costs to be passed through to consumers in lower prices, lowering price inflation relative to nominal wage change. this decline in inflation, in turn, will put some downward pressure on nominal wage gains. the net result is that an unanticipated increase in the rate of growth of productivity is another example of a favorable supply shock, temporarily lowering inflation. it is useful, nevertheless, to distinguish price shocks – such as declines in energy or non - oil import prices – from productivity growth shocks that have their initial effects on costs rather than on prices. during a transitional period following an unexpected increase in the productivity trend,