- probability outcomes. and i see several sources of uncertainty in addition to those associated with the intensity of the hurricane disruptions and the timing and extent of rebuilding. one source of uncertainty involves the reactions of households and businesses to higher prices of petroleum products and natural gas. by their nature, such price increases point to downside risks to demand and output - - especially when they are associated with supply disruptions - - and upside risks to inflation. although households seem to have cut back spending moderately in response to increases in energy prices this year, surveys suggest that they are now feeling the pinch of higher energy prices. prices of gasoline should continue to retrace their post - katrina upsurge, but natural gas prices are likely to remain high for some time, and consumers could cut spending by more than is currently anticipated over coming months, which could then feed back on business capital spending. at the same time, however, persistently high energy prices also raise the possibility that inflation expectations could ratchet higher, even if core inflation remains fairly low in the short run. if expectations did become less well anchored, core inflation could subsequently rise and the higher level could persist. 3 / 4 another source of uncertainty is the housing market. it is possible that the rapid increases in house prices could simply be a reflection of fundamental forces such as an increase in land use restrictions and other legal restraints on building, innovations in mortgage finance, changes in tax laws and low interest rates. but it could also be the case that much of the very rapid increase in prices very recently has been based on the expectation that the pace of past increases will extend into the future. or perhaps the increases also have been fueled by eased lending standards that could well be tightened in response to slower price appreciation. if expectations have been realistic and lending practices only marginally important, a slowdown in house - price appreciation could be gradual and the consequences for consumption growth could be modest ; indeed, as signs of a slowdown are still quite tentative, continued strength in house prices are an upside risk to any easing of demand going forward. but if disappointed expectations or considerably tighter credit foster more severe or more abrupt price adjustments in enough local housing markets, psychology could amplify the effects of diminished wealth to restrain consumer spending. economists, including those at central banks, simply are not very good at understanding, much less predicting, the dynamics of asset price adjustments ; and i would guess that our ignorance is especially profound when those dynamics may be in the process of shifting.

less rapidly. firms had built inventories at a rapid clip in 2004 and the first part of this year, and by late winter many businesses seemed to have been more satisfied with their inventory positions. consequently, they scaled back rebuilding efforts and trimmed the growth of production accordingly. still, activity rose rapidly enough to further erode margins of economic slack. the unemployment rate fell from 5. 4 percent at the end of last year to 4. 9 percent in august, and the rate of capacity utilization continued to rise toward its long - run average, though that increase was slowed with the production adjustment in the spring. measures of labor compensation have given somewhat mixed signals about how tight labor markets have become. the rate of increase in the measure of compensation per hour derived from the national income and product accounts moved up appreciably over the four quarters ended in mid - 2005 compared with the preceding year. this rise was apparently due in part to bonuses and stock options that may be only loosely related to labor market slack, however. moreover, according to the employment cost index, which is based on a survey of firms, and to the growth in average hourly earnings in the payroll employment report, compensation pressures remained quite subdued. on balance, i do not believe conditions in labor markets have become excessively taut, but experience suggests remaining humble in making any such assessment. i would like to thank stacey tevlin, lawrence slifman, vincent reinhart, and david stockton, of the board's staff, for valuable comments. 1 / 4 measures of core consumer inflation eased some over the late spring and early summer, even as headline inflation was pushed higher by rising energy prices. in addition to the favorable news on core inflation, observations from the financial markets showed that forward measures of inflation compensation beyond the next few years - - the difference between distant forward rates on nominal and indexed debt - - moved down over the spring, despite the rising energy prices. even so, core inflation had moved higher in 2004, interest rates were still low, and the economy seemed to be expanding at a pace that over time could threaten to impart added upward pressure on inflation. as a consequence, the fomc indicated in its august announcement that its intention, in the absence of unexpected developments, was to continue to remove monetary policy accommodation at a measured pace. hurricanes are obviously the very embodiments of unexpected developments. among other effects of hurricanes katrina and rita, they have materially increased uncertainty about the economic outlook. the questions