us growth portends a softening elsewhere, or whether other regions are big enough and internally vibrant enough to carry on growing reasonably well in the face of the us slowdown. to a large extent this will hinge on how widely the slowing extends within the us economy itself, and how long it lasts. to date, it has been largely confined to a reduction, albeit a pretty large one, in construction of dwellings, after a period of unusually strong activity in that sector. people have been asking whether it will spread further, especially given the recent travails in the sub - prime mortgage market, which had at the peak accounted for about 15 per cent of mortgage loans made to us households. a decline in credit standards during 2006, as lenders sought to keep business growing in the face of the slowing demand for loans and a change in trend in house prices, has since resulted in a rise in loan arrears. in turn, this has resulted in a blow - out in spreads on the low - rated tranches of the securities issued by some of the us lenders active in this market, and a number of loan originators in the sub - prime space went out of business. there was understandably a concern that this sequence of events could prompt a pulling back by lenders for housing generally, which would deepen the downturn in construction. there was also a possibility that there would be a more widespread reassessment of risk and a tightening in credit across the us economy, so dampening growth more generally. but so far, the us economy and financial system seem to be absorbing the sub - prime problems pretty well. there has been a significant tightening in credit standards in the sub - prime area, as there had to be, but no widespread withdrawal by lenders more generally. while the us housing sector has yet to show much convincing sign of a pick - up in construction, the softness in the us economy does not seem to have spread to consumer spending, as incomes have been supported by ongoing gains in employment. that does not necessarily mean we have seen the last of concerns about us weakness but, at the moment at least, adjustments to the growth outlook are at the margin, rather than amounting to a wholesale re - think of economic prospects. it is also noteworthy, and very important from a global perspective, that underlying inflation appears to have come down in the us somewhat over the past six months, having drifted higher for the previous six months. low and stable inflation has

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