inflation from its already low level. in these circumstances, monetary policy is able to be more patient. that said, no central bank can ever afford to be less than vigilant about the prospects for inflation. * * * the foregoing relatively optimistic short - term outlook for the u. s. economy is playing out against a backdrop of growing longer - term concern in financial markets about our federal budget. as you know, the congressional budget office is projecting that, if current policies remain in place, the unified budget will post deficits throughout the remainder of this decade - a sharp turnaround from the large and growing surpluses projected just a few years ago. given the events of the past three years - the economic downturn, the retrenchment in equity markets, the increased need for spending on homeland security, and the wars in afghanistan and iraq - some deterioration in the federal budget balance was probably unavoidable, particularly in the short term. one source of deterioration - the buildup of a larger military force structure - will not persist indefinitely. merely maintaining a given force structure rather than increasing it will remove an important factor driving the deficit higher. of course, the deterioration in the fiscal balance has already increased the level of debt relative to gdp, and thus has elevated the starting point from which policymakers will soon have to address the budget implications of the impending retirement of the baby - boom generation. recent budget deliberations are not encouraging. the current debate appears to be about how much to cut taxes or how much to increase spending. no significant constituency seems to support taking the actions that will be necessary to move toward, and one hopes achieve, budget balance. in retrospect, the emergence of budget surpluses in the late 1990s eroded the discipline that emerged as a consequence of the earlier fear of ever rising and, hence, potentially destructive deficits. indeed, many of the rules that helped to discipline budgetary decisionmaking in the 1990s - in particular, the statutory limits on discretionary spending and the so - called paygo rules - were allowed to expire. many analysts properly continue to be concerned that, without these enforcement mechanisms and the fundamental political will they signal, the built - in bias in favor of red ink will once again become entrenched. policymakers have become all too aware that government spending programs and tax preferences can be easy to initiate but extraordinarily difficult to shut down once constituencies develop that have a stake in maintaining the status quo. the now -

of growing output and falling hours worked was made possible by a startlingly large rise in productivity. indeed, since the fourth quarter of 2001, output per hour in the nonfarm business sector has increased 5 percent at an annual rate. and during the second and third quarters of this year, output per hour increased at the astonishing average annual pace of about 7 - 1 / 2 percent. this outcome has been associated with a dramatic increase in profits despite little evidence of corporate pricing power. the explanations of the past two years ’ surge in productivity are wide - ranging. one hypothesis is that some of the increase represents a temporary rise in the level of productivity reflecting a view that an unusual amount of caution is leading businesses to press workers and facilities to a greater degree than can be sustained over the longer haul. by this hypothesis, as that caution dissipates, employment growth will pick up and the level of output per hour will drop back. another hypothesis is that the level of productivity has undergone a one - time permanent upward shift. this hypothesis builds on the idea that the heavy emphasis on exploiting new and expanding markets from 1995 to 2000 likely diverted some corporate management from the hard work of controlling costs. the payoffs from cost control doubtless seemed small relative to those thought to attend big - picture expansion. but with tepid sales growth, uncertainty about the strength of future demand, and a fierce discipline exerted by financial markets, companies have been forced to search aggressively for ways the views i will be expressing are my own and not necessarily those of the federal reserve board. to use resources more efficiently, to cut costs, and restore operating profit margins. the extent to which businesses have succeeded in boosting output with fewer labor hours and minimal capital investment over the past two years points up the possibility that a considerable stock of inefficiencies accumulated in the boom years and that this stock is still being worked off. finally, yet another hypothesis stresses a more - lasting increase in the growth of output per hour. this notion focuses on the considerable lag between the introduction of new technologies and their full integration into production processes and business practices. to reap the full benefits of technological innovation takes learning time, especially if there are large synergies through network effects. of course, given the exceptionally high rate of growth in output per hour over the past two years, some combination of short - term and longer - term productivity - enhancing forces seems likely to have been at work. in any event, one consequence of