the economy. in response, policy makers clearly have to work hard at understanding the effects of changes in economic and financial behaviour and the way they affect the transmission channels. they need to monitor a wide range of indicators to assess both financial conditions and the impact of their decisions on the economy. it is also important to monitor closely and respond to developments around the globe, as recent events have demonstrated that these can be rapidly transmitted across borders. in addition, monetary policy authorities need to work in collaboration with regulators and those responsible for financial stability to build their understanding of the financial system. in the short term, the situation requires flexibility and a degree of innovation on the part of central banks, and on occasion not a little boldness. i think most central banks have been prepared to embrace those principles, without abandoning the long term foundations on which credible policy making must rest. as challenging as the current environment is, however, some big challenges loom for the longer term, once the emergency has been dealt with. complexity and uncertainty have always been defining characteristics of the economy. economic behaviour and the structure of the financial system and economy are continually evolving. it will never be possible for central banks or others to work with full information, nor to predict exactly how their actions will be passed through the financial system, nor how they will affect the economy. the financial crisis may lead to a certain simplification of the financial sector for a time, with the closure of markets for many complex products, banks moving towards more narrow, traditional business models and the disappearance of some highly leveraged institutions with complex business structures. but the global nature of financial activity and the importance of markets to financial institutions are likely to remain, and the cycle of risk taking will eventually turn. we certainly want this to be the case, in my view. the problem in the next couple of years will not be too many cross border capital flows, but too few ; not too much risk taking, but too little. a retreat into financial autarky and wholesale shunning of risk would be even more damaging than what we have seen to date. so the challenge in the longer term is to construct a policy regime that handles all the complexity and cyclicality of the system. we need a robust policy regime that can operate effectively, on the assumption that we will never have the full picture of the workings of the financial system and the real economy. we need policies that can be effective on the assumption that private financial systems are periodically prone to “ irrational exuber

well as to the demand side. observers conventionally assess the outlook for growth by looking at the prospects for demand components, adding them up, and then assuming that supply will respond. anything that stimulates demand is thought to be “ good for the economy ”. but over recent years, we have increasingly been reminded that it is the economy ’ s supply side performance – the quantity and quality of the capital stock, the availability of labour and the productivity with which both those factors are used – that ultimately determines its rate of growth over the long term. demand management policies – monetary policy and government spending and taxation measures designed to have a broad economic impact – can usually ensure that there is adequate expenditure to use the economy ’ s productive resources. but while we can, in most circumstances, create additional demand, it is much harder to create additional supply. unless additional supply is somehow forthcoming, however, expanding demand just produces overheating and inflation. inflation did pick up in australia during the middle years of the current decade, from 2. 4 per cent in 2003, to 2. 6 per cent in 2004, 2. 8 per cent in 2005, and 4 per cent by mid 2006. that peak in the cpi inflation rate was affected by some temporary factors, which have now reversed. but measures of inflation designed to extract the underlying trend showed a pick - up too, from about 2½ per cent to 3 per cent during the first half of last year. the most recent data for inflation, however, showed a more welcome trend, with underlying measures of inflation running at a reduced pace and the cpi rate on its way down as well. in our statement on monetary policy released about six weeks ago, our judgement was that underlying inflation would probably run at about 2½ per cent for the year 2007, which was a slight downward revision to earlier expectations. data on labour costs received since then add credence to that forecast. compared with what we expected a year ago, then, growth has turned out to be stronger, employment higher, but underlying inflation a little lower, and wages growth has been steady in the face of unanticipated labour market strength. this is quite a favourable set of outcomes, and should prompt us to ask how it all fits together. one possibility is that all we are observing is lags at work. earlier national accounts showed a weakening in growth from mid 2005 through to mid 2006. perhaps this led, with a lag, to the slowing in prices recorded in recent quarters