##liplier - accelerator process. that is, an unexpected demand shock results in higher output and income, which, in turn, further boosts consumption and investment, reinforcing the effect of the errors on income and output. this is also part of the story of faster - than - expected output growth in 1997. but unexpected strength in aggregate demand is usually damped by more restrictive financial conditions, by some combination of monetary tightening and movements in longer - term interest rates. while a ¼ percentage point increase in the funds rate was implemented last march, financial conditions, more broadly, became increasingly supportive rather than more restrictive as the year progressed. real long - term interest rates, measured using surveys of inflation expectations, were steady to declining over the year, likely reflecting a smaller - than - anticipated budget deficit and an unwinding of expectations of tighter monetary policy. nominal rates matter, too, especially for housing, and longer - term nominal rates fell, due to the lower - than - expected inflation. equity prices unexpectedly soared, reinforcing the strength of both consumption and investment. so, instead of financial conditions dampening the demand shocks, as would normally be the case, more supportive financial conditions actually reinforced them. this is another piece in the puzzle. financial conditions remained supportive partly because the better - than - expected inflation outcome kept the fed from raising the federal funds rate, except for the single ¼ percentage point move in march. the decline in inflation, in turn, reflected reinforcing effects of a sharp decline in energy prices, a significant slowing in the increase in food prices, and a further decline in core inflation. overall cpi inflation was widely expected to slow because of a projected reversal of the sharp rise in oil prices over 1996. about one percentage point of the slowing of overall cpi inflation over 1997 was, in fact, due to the relative movements of food and energy prices over 1996 and 1997. this was a somewhat sharper effect than was anticipated at the beginning of the year and accounts for a small part of the forecast error on inflation. but the greater surprise was the decline in core inflation. a major source of this error was the unexpected further appreciation of the dollar and thus the renewed decline in import prices. the dollar had been expected by many to stabilize in 1997. instead, it appreciated sharply, by 11½ % based on the multi - lateral trade weighted index of other g - 10 currencies and by even more for broader indexes that include other major trading partners. continuing sharp declines

, what happens to utilization rates, and how the movement in utilization rates interacts with the other cross - currents affecting inflation. a much larger spillover from the asian crisis could encourage an easing. continued above - trend growth and a further rise utilization rates, on the other hand, could encourage further tightening. but i want to focus on two intermediate outcomes, both because i view these as more likely and because they would raise more interesting questions for monetary policy. the first scenario i call a graceful “ reverse soft landing ”. this is my interpretation of the private sector consensus forecast. as i noted earlier, in a soft landing, growth slows from an above - trend to trend rate just as output converges from below to its full employment level. but i believe output is already beyond the full employment level. a soft landing in this case requires growth to run below trend for a period to allow productive capacity to catch up to demand and to allow utilization rates to ease to sustainable levels. ordinarily, inflation would be rising during the transition, given initial conditions of output in excess of sustainable capacity. but, in the current episode, the virtuous cycle in play and renewal of forces that have recently been restraining inflation will continue to damp inflation over 1998, at least moderating the rise in inflation that would otherwise occur. in this scenario, real growth slows to around 2 % or slightly lower, the unemployment rate edges upward, but remains below nairu over 1998, and inflation is slightly higher. this is a path back toward full employment, leaving inflation higher but still modest once full employment is reached, perhaps by the end of 1999. how should monetary policy respond in this scenario? should policy ease in response to the sharp slowing in growth and rise in the unemployment rate? or should policy remain on hold, allowing the economy to converge slowly back to full employment and a still modest inflation rate? given the momentum in domestic demand, the still favorable financial conditions and other fundamentals, questions about the degree of spontaneous slowing, and uncertainty about the magnitude of the spillover from the asian crisis, an equally plausible forecast is that growth slows, but only to trend. in this case, the unemployment rate would remain near its current level and inflation would increase slightly more than in the first scenario, though it would still be damped in 1998 by the virtuous cycle forces and the continued favorable supply shocks. this scenario would, however, imply greater inflation risks going forward, in light of prospects that the