##ary effect. this arises, in my view, because of an asymmetry in the response of wages and prices to the acceleration in productivity, perhaps because salaries and wages are typically adjusted only once a year or, perhaps because of wage norms that cause employees to expect compensation growth similar to the experience over previous years. whatever the reason, nominal wages initially do not appear to respond very much to the acceleration in productivity. as a result, the higher productivity lowers the cost of production. this has the immediate effect of raising profits, but competition soon puts downward pressure on prices, lowering inflation. the lower inflation, in turn, restrains nominal wage demands, contributing for a time to a virtuous cycle of lower wage change and price inflation. in the appendix, i present a simple model that incorporates this asymmetric response. the demand and direct disinflationary effects have conflicting implications for inflation. the abovetrend growth associated with the demand effect lowers the unemployment rate, and the tighter labor market puts upward pressure on inflation. the direct disinflationary effect, on the other hand, lowers inflation for any given unemployment rate. the net effect could be steady, rising, or falling inflation - depending on whether productivity continues to accelerate and on how low the unemployment rate is driven in the process. and, of course, the appropriate course of monetary policy depends on the balance between these two effects. 2 the interaction of these two short - run effects can also be explained in terms of the relationship between the unemployment rate and the nonaccelerating inflation rate of unemployment ( nairu ). the nairu is the unemployment rate consistent with steady inflation. in computing the nairu, the customary practice is to abstract from shocks that directly affect inflation over and above the influence of demand pressure - for example, accelerations or decelerations in trend productivity and swings in the relative price of oil are not taken into consideration. in fact, if there were no shocks, the direction of inflation ultimately would be uniquely determined by the relationship between the unemployment reflecting the absence of a consensus about the short - run effects of an acceleration in productivity, most macroeconomic models do not fully incorporate either of these effects. the model used for policy analysis at the board, the frb - us model, however, explicitly incorporates both of them. there are other complications. for example, the acceleration in productivity has contributed to the swing from deficit to surplus in the federal budget and appears to have encouraged an appreciation of the

the other hand, capacity utilization rates show no signs of excess demand in product markets. it is excess demand that gives pricing leverage to firms. the absence of pricing leverage by firms, as a result of an absence of demand pressure, induces firms to work hard to restrain wage increases or to offset them with productivity gains. let me sum up my interpretation of the recent unemployment and inflation experience. economic performance has truly been excellent over the past year with a particularly impressive combination of low core inflation and low unemployment in 1996. but this performance does not suggest that the business cycle is dead or that the phillips curve is no longer relevant. the decline in core inflation during 1996 most likely reflects the role of a coincidence of favorable supply shocks. developments in labor markets over the last few years do provide a hint of a modest decline in nairu, but the evidence is not definitive and it remains uncertain whether any decline in nairu is temporary or permanent. consequently, a prudent monetary policy would be based on a working assumption that the underlying trend of inflation has been stabilized in the past couple of years and that we shall have to maintain a close watch for signs that inflationary pressures are mounting. challenges for monetary policy let me turn now to the implications of the economic outlook for challenges to monetary policy. i ’ ll discuss five challenges, three faced and met earlier in the expansion, one currently in play, and a fifth that deserves attention. the first challenge was the more erratic and, on average, slower pace of recovery following the last recession. this was due, in large measure, to the weight of a series of structural imbalances inherited from the previous expansion. in response to the unique features of the recovery, monetary policy remained unusually stimulative long into the expansion, with the federal reserve maintaining a 3 % nominal federal funds rate and near - zero real federal funds rate for three years into the current expansion. the next challenge came when the “ headwinds ” began to abate and the economy was poised to move to more robust growth in 1994, at a time when the unemployment rate had already declined from its cyclical high to closer to estimates of full employment. the timing and aggressiveness of federal reserve tightening over 1994 met the second challenge, preventing overheating. the third challenge was to adjust monetary policy, once the economy showed signs of slowing in early 1995, to avoid overkill and set the foundation for trend growth near full employment with stable inflation. the two most common errors in cyclic