##hang of owner - occupied units ; hence, i do not expect rents to be a major influence on core inflation a year or two from now, the horizon that is the focus of monetary policymaking. clearly, however, the band of uncertainty about such a forecast is rather wide. not only should the contribution of energy and shelter costs to underlying inflation be diminishing over coming quarters, but the generalized pressure of demand on supply should also decrease if, as i am anticipating, economic growth falls short of potential for a time. i would not expect modest changes in the output gap to exert more than a marginal influence on inflation. but the anticipated slower pace of growth will result in an environment in which firms will be less able to pass on increases in costs. one potential source of higher costs comes from the labor market. i would not be surprised to see a gradual rise in labor costs as workers capture a greater share of the productivity gains of recent years. however, compensation per hour, a measure derived from unemployment insurance tax records, indicates that labor costs accelerated sharply, to a pace of 7 - 3 / 4 percent from the second quarter of 2005 to the second quarter of 2006. in contrast, readings from the employer cost index ( eci ), which is derived from a probability sample of firms, shows labor costs decelerating. some of the divergence appears to be the result of an increased volume of stock option exercises in early 2006 - an occurrence captured by the compensation per hour measure but not by the eci - and these option exercises should not represent costs that firms actually internalize when calculating their marginal cost of production. thus, in my own thinking, i have tended to discount, though not dismiss, the latest readings on labor costs. however, i acknowledge that rising labor costs are an upside risk to my inflation outlook, especially if they occur under product - market conditions in which firms can readily pass costs through. in sum, i think that the odds favor a gradual reduction in core inflation over the next year or so, but the risks around this outlook do not seem symmetric to me : important upside risks to the outlook for inflation warrant continued vigilance on the part of the central bank. i say that not only because of the questions about underlying labor costs and about the future direction of energy and shelter prices but also because our understanding of the inflation process is limited, and i cannot rule out the possibility that the upward movement earlier this year reflected a more persistent impulse that i cannot now identify

to a post - world war ii high of 2. 2 million units last year. sales of new and existing homes followed the same broad pattern, and the boom in residential real estate markets was a powerful force driving the post - 2000 economic expansion. monetary policy played an important role in these developments : responding to the weakness in other sectors of the economy, the fomc held short - term interest rates at unusually low levels over much of this period. with inflation expectations well contained, with investment weak relative to saving in other countries, and with investors requiring much less extra compensation for holding longer - term obligations, longterm mortgage rates also dropped to historically low levels. housing affordability increased substantially, and the homeownership rate hit new highs. in addition, a speculative element may have emerged in this market as investors projected rapid price increases into the future. and those price increases were considerable. between the beginning of 2001 and the end of 2005, the constant - quality price index for new homes rose 30 percent and the purchase - only price index of existing homes published by the office of federal housing enterprise oversight ( ofheo ) increased 50 percent. these increases boosted the net worth of the household sector, which further fueled the growth of consumer spending directly through the traditional " wealth effect " and possibly through the increased availability of relatively inexpensive credit secured by the capital gains on homes. by the end of last year, however, the high price of houses and rising interest rates had begun to take a meaningful toll on demand for homes. determining the exact timing of the recent peak in the housing market is difficult given the effects of last year's hurricanes, the volatility in the data, and timing differences in the evolutions of home sales and housing starts. that said, the fourth quarter of last year seems to provide a reasonable reference point : since that time, housing starts have fallen about 20 percent, and home sales are down 10 percent. home - price appreciation has also slowed dramatically since late last year, and some local markets have experienced outright price declines. homebuilders report that cancellations have increased sharply, especially for second homes. realtors note that existing houses are staying on the market longer, and sellers must increasingly make concessions to buyers. how much longer will the correction in housing last, and how much deeper will it go? i do not have a definitive answer but would venture four observations. first, the reported declines in new home prices in a number of areas should help to facilitate the