to hold capital commensurate with the actual risks of such transactions. recent market events highlight why a robust and independent assessment of risk on the part of banks is so important. the enhanced risk - sensitivity of the basel ii advanced approaches creates positive incentives for banks to lend to more - creditworthy counterparties and to lend against good collateral, by requiring banks to hold more capital against higher - risk exposures. the federal reserve's role as the nation's central bank reinforces our belief in the importance of maintaining prudent and risk - sensitive capital requirements for financial institutions. financial stability is enhanced when banks'regulatory capital measures adequately reflect risk, as well as when banks continually improve their risk - management practices. since the basel ii regime is far superior to the current basel i regime in aligning regulatory capital requirements with risk and fostering continual improvements in risk management for our largest and most complex banking organizations, i believe it will contribute to a more resilient financial system as a whole. in addition, let me emphasize that the basel ii regulatory capital framework establishes a more coherent relationship between regulatory measures of capital adequacy and the day - today risk management conducted by banks. that is, it builds on risk - management tools, such as credit - risk rating systems and economic capital, that are already in use at sophisticated financial institutions. as a result, basel ii will be better able than the current system to adapt over time to innovations in banking and financial markets and will reduce incentives for arbitrage that arise from the gap between what the regulators require and what sound economic risk management requires. moving ahead with basel ii implementation next steps for supervisors i used the analogy of running a marathon earlier, describing how the final rule represented a finish line of sorts for the u. s. banking agencies. alas, i'm afraid that we cannot rest because in fact we have simply passed the baton from the runner in the first stage of the race – rule finalization – to the runner in the next stage – implementation. successful implementation of basel ii will require additional hard work and determination. as most of you know, the agencies have for some time been preparing for basel ii implementation by working to integrate basel ii into our day - to - day supervisory processes. with completion of the final rule, we must now be ready to pace ourselves through another long, intensive, but ultimately rewarding, effort. the agencies are already working hard to foster consistency across banks and across the agencies. we are building

a third area of uncertainty concerns the broader macroeconomic risks to the inflation outlook. one risk is a possible substantial tilt up in the growth of compensation per hour as workers try to offset some of hit to their real incomes from higher energy prices at a time of relatively full resource utilization. a second risk is a possible slowing in underlying productivity growth from the substantial gains of the past decade toward the more subdued pace of the preceding quarter century. if both possibilities were to be realized over the next year, unit labor costs could surge, putting severe upward pressure on prices. profit margins are elevated and competitive pressures could force firms to absorb a good portion of those cost increases. but they would not do so willingly or completely. to the extent that firms were able to exercise pricing power and maintain margins, rising costs would feed through to greater inflation. this is not, however, what i expect to happen. as i noted already, productivity has been well maintained and despite mixed signals, the growth of labor compensation does not appear to be accelerating noticeably. but i will be paying close attention to developments in costs as well as in prices as i update my inflation forecasts in the future. in sum, i see risks on both sides of my expectations that the growth of economic activity will slow modestly on balance over the next year or so, leaving the economy producing at about its sustainable potential. but unless activity slows unexpectedly, and after the rise in retail energy prices, the risks may be skewed a little toward the upside on inflation. because the economy is producing at a reasonably high level and activity is most likely on a solid upward track, my focus at this time is naturally on keeping inflation contained. our economy works best when households and businesses do not need to take account of persistent increases or decreases in the general price level in making their decisions about spending and production. low inflation also makes policymaking easier because a high degree of confidence by households and firms that inflation will remain low gives the federal reserve added latitude to move aggressively against any economic weakness that may develop. and a lesson of the 1980s is that it is costly to wring inflation out of the system once it becomes entrenched. i do not know what path of rates will, in fact, be required to accomplish our objectives. obviously, we are considerably closer to where policy needs to be than we were sixteen months ago, but we are not yet at a point where we can stop and watch the economy evolve for a while. but you should appreciate that