rather on a series of potential outcomes and the possible effects of alternative policies, including judgments of the consequences of taking a policy action that might, in the end, have turned out to be less than optimal. i viewed our small increase in the federal funds rate on march 25 as taken not so much as a consequence of a change in the most probable forecast of moderate growth and low inflation for later this year and next, but rather to address the probability that being wrong had materially increased. in the same sense that it would be folly not to endure the small immediate discomfort of a vaccination against the possibility of getting a serious disease, it would have been folly not to take this small prudent step last march to reduce the probabilities that destabilizing inflation would re - emerge. the risk to the economy from inaction came to outweigh the risk from action. to be sure, 1997 is not 1994 when the fed was forced to tighten monetary conditions very substantially to avoid accommodating rising inflation. current financial conditions are much less accommodative than they were in 1994. yet we must be wary. while there is scant evidence of any imminent resurgence of inflation at the moment, there also appears to be little slack in our capacity to produce. should the expected slowing in the growth of demand fail to materialize, we would need to address any emerging pressures in product and credit markets. to understand the problems of capacity restraint, i should like to spend a few moments on what we have learned over the years about economic growth and the conditions necessary to foster it. first it is useful to distinguish between two quite different types of economic growth. one is true, sustainable growth, the other is not. true growth reflects the capacity of the economic system to produce goods and services and is based on the growth in productivity and in the labor force. that growth contrasts with the second type, what i would call transitory growth. an economy producing near capacity can expand faster for a short time through excess credit creation. but this is not growth in any meaningful sense of promoting lasting increases in standards of living for our nation. indeed, it will detract from achieving our long - term goals. temporary fluctuations in output owing to say, inventory adjustments, but not financed through excess credit, will quickly adjust on their own and need not concern us as much, provided policy is appropriately positioned to foster sustainable growth. when excessive credit fostered by the central bank finances excess demand,

a second question is, how we can structure these requirements and other aspects of regulation to damp, rather than reinforce, the natural procyclical tendencies of the financial system? among the challenges will be encouraging firms and supervisors to comfortably allow buffers to be eroded in bad times. interestingly, prompt corrective action under the federal deposit insurance corporation improvement act of 1991 was intended, in part, to induce an element of countercyclical behavior by banks. it gives banks an incentive to build excess capital – on both a risk - based and leverage ratio basis – in good times to avoid prompt corrective action when circumstances are less favorable. now that we are in the latter state of the world, a study of how commercial banks are viewing capital ratios, including the leverage ratio, could inform consideration of the morris and shin proposal. the morris and shin paper also provides a framework for thinking about the federal reserve's credit facilities. on page 9, they note that liquidity makes borrowers feel more robust and lenders less likely to withdraw, raising the odds for a more stable equilibrium for the entire system. that is exactly what we have been trying to do with our various discount lending facilities. the assurance of the availability of liquidity to sound institutions against good collateral should counter the greater uncertainty and risk aversion that have impaired normal arbitrage and intermediary functions by making those institutions more willing to extend credit and take positions in the process of making markets. it should also assure other creditors of those institutions that illiquid markets will not impede the repayment of their loans, and therefore make them more willing to keep lending. a number of markets remain disrupted and illiquid. but i believe that they would have been even more illiquid and the risk of disruptive runs even greater without our various facilities ; that's certainly what market participants are telling us. jan hatzius is trying to gauge the combined effects on spending of the losses generated by the effects of the decline in housing prices outlined in the case paper and the impulse for deleveraging in the financial sector inherent in the processes discussed by morris and shin. to restore capital ratios depleted by mortgage losses and to raise those ratios even further in order to reduce leverage to safer levels demanded by counterparties, banks and other lenders need to reduce assets. they do so by tightening terms and standards across a broad array of credit – and we have seen this behavior reflected in our surveys of bank lending officers and in various