after falling to 7 percent in the third quarter of 2001, rebounded to 12 percent in the first quarter of 2004, a pace of advance not experienced since 1983. half of this rise in the profit share occurred between the first quarter of 2003 and the first quarter of 2004, a period during which business costs were unusually subdued. in fact, consolidated unit costs for the nonfinancial corporate business sector actually declined during this period. the increase in output per hour in the nonfinancial corporate business sector of more than 6 percent accounted for much of the net decline in unit costs. the remainder was due to the effects of rising output in reducing nonlabor fixed costs per unit of output. hence, at least from an accounting perspective, between the first quarter of 2003 and the first quarter of 2004, all of the 1. 1 percent increase in the prices of final goods and services produced in the nonfinancial corporate sector can be attributed to a rise in profit margins rather than rising cost pressures. however, businesses are limited in the degree to which they can raise margins by raising prices. an increase in margins should affect mainly the level of prices associated with any given level of unit costs but, by itself, should not prompt a sustained pickup in the rate of inflation going forward. in a market economy, any tendency for profit margins to continue to rise is countered largely by the entry of new competitors willing to undercut prices and by increased labor costs as more firms attempt to exploit the opportunity for outsized profits by expanding employment and output. that increase in competitive pressure, as history has amply demonstrated, with time, returns markups to more normal levels. over the past three decades, the share of the profits of nonfinancial corporations in the total nominal income of that sector has fluctuated around a longer - run average of roughly 10 - 1 / 2 percent. the profit share in the first quarter of this year, at about 12 percent, was well above that level. the gap suggested that the growth of unit profits would eventually slow relative to increases in unit costs. this outlook had accorded with analysts ’ expectations for earnings growth over the next year, which are substantially below the realized growth of profits in recent quarters. indeed, some leveling or downward pressure on profit margins may already be in train, owing to a pickup in unit labor costs. although advances in productivity are continuing at a rate above the longterm average, they have slowed from the extraordinary pace of last summer and are

demand has risen with the pace of world economic growth. yet aside from energy, markets exhibit little evidence of heightened perceptions of risk. credit spreads remain low, and market - based indicators of inflation expectations, after rising earlier this year, have receded. with the growth of aggregate demand looking more sustainable and with employment expanding broadly, the considerable monetary accommodation put in place starting in 2001 is becoming increasingly unnecessary. in may, the fomc believed that policy accommodation needed to be removed and that removal could be accomplished at a pace that is likely to be measured. at our meeting last month, the fomc raised the target federal funds rate from 1 percent to 1 - 1 / 4 percent, and the discount rate was raised commensurately. policymakers reiterated that, based on our current outlook, the removal of accommodation would likely proceed at a measured pace. but in light of the considerable uncertainty surrounding the anticipated evolution of price pressures, the fomc emphasized that it will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability. if economic developments are such that monetary policy neutrality can be restored at a measured pace, a relatively smooth adjustment of businesses and households to a more typical level of interest rates seems likely. even if economic developments dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates. of course, considerably more uncertainty and hence risk surrounds the behavior of the economy with a more rapid tightening of monetary policy than is the case when tightening is more measured. in either scenario, individual instances of financial strain cannot be ruled out. the protracted period of low interest rates has facilitated a restructuring of household and business balance sheets. businesses have been able to fund longer - term debt at highly favorable interest rates and, by extending the maturity of their liabilities, have rendered net earnings and capital values less exposed to destabilizing interest rate spikes. households have made similar adjustments. between mid - 2002 and mid - 2003, homeowners were able to refinance at lower interest rates almost half of total outstanding home mortgage debt and thereby to substantially reduce monthly debt service payments. households also substituted mortgage debt for more - expensive consumer credit. moreover, those households and businesses that held long - term investment - grade bonds in that year accumulated realized and unrealized capital gains as long - term rates declined. the fomc judged this extended period of exceptionally