##ility – we should always keep in mind how little we know about the economy. monetary policy operates in an environment of pervasive uncertainty – about the nature of the shocks hitting the economy, about the economy ’ s structure, and about agents ’ reactions. the 1970s provide a sobering lesson in the difficulty of estimating the level and rate of change of potential output ; these are quantities we can never observe directly but can only infer from the behavior of other variables. we cannot effectively implement policy without some reference to the likely level of potential, given that demand - supply pressures are an integral part of the monetary transmission mechanism. but we must be realistic about the accuracy of our estimates of potential while always doing our best to improve them. even today, we face a number of sources of uncertainty about the nature of the inflation process. interestingly, we can draw several examples from the paper. first, any estimate of the persistent component of inflation is inherently uncertain. comparing the trend inflation estimates for the gross domestic product of the united states in the current study with related estimates based on stock and watson ’ s recent paper on the topic reveals an important difference : in the latter, the standard deviation to the innovation of the permanent component of inflation from 1997 onward is not zero but rather permits a small but significant amount of drift in the trend from its late - 1990s trough. 2 other trend - extraction exercises imply either a stable trend or a trend that has drifted up over the past several years ; likewise, the behavior of estimated trend inflation over this period differs according to the inflation concept used. although these differences are small relative to the overall variation in the trend over the past forty years, they are assuredly large enough to be meaningful to a monetary policy maker. in addition, we do not yet have a consensus structural model of inflation dynamics that satisfactorily explains all the important aspects of the empirical data. as the paper demonstrates, a standard workhorse model – a sticky - price business cycle model with a drifting inflation target and a new keynesian phillips curve – cannot mimic one important feature of the inflation process. i will leave it to the modelers to debate the seriousness of this deficiency and to propose how it might be rectified. however, it is clear to me that our understanding of the inflation process still has far to go. the issue of expectations illustrates our ignorance. as i have already indicated, inflation expectations are among the most important variables policymakers monitor, but we do not have answers to

, have overcompensated in response, and then have been forced to retrench - - a not - unusual occurrence in business decisionmaking. a pace of change outstripping the ability of people to adjust is just as evident among consumers as among business decisionmakers. when consumers become less secure in their jobs and finances, they retrench as well. it is difficult for economic policy to deal with the abruptness of a break in confidence. there may not be a seamless transition from high to moderate to low confidence on the part of businesses, investors, and consumers. looking back at recent cyclical episodes, we see that the change in attitudes has often been sudden. in earlier testimony, i likened this process to water backing up against a dam that is finally breached. the torrent carries with it most remnants of certainty and euphoria that built up in earlier periods. this unpredictable rending of confidence is one reason that recessions are so difficult to forecast. they may not be just changes in degree from a period of economic expansion, but a different process engendered by fear. our economic models have never been particularly successful in capturing a process driven in large part by nonrational behavior. although consumer confidence has fallen, at least for now it remains at a level that in the past was consistent with economic growth. and as i pointed out earlier, expected earnings growth over the longer - run continues to be elevated. if the forces contributing to long - term productivity growth remain intact, the degree of retrenchment will presumably be limited. prospects for high productivity growth should, with time, bolster both consumption and investment demand. before long in this scenario, excess inventories would be run off to desired levels. still, as the fomc noted in its last announcement, for the period ahead, downside risks predominate. in addition to the possibility of a break in confidence, we don't know how far the adjustment of the stocks of consumer durables and business capital equipment has come. also, foreign economies appear to be slowing, which could damp demands for exports ; and, although some sectors of the financial markets have improved in recent weeks, continued lender nervousness still is in evidence in other sectors. because the advanced supply - chain management and flexible manufacturing technologies may have quickened the pace of adjustment in production and incomes and correspondingly increased the stress on confidence, the federal reserve has seen the need to respond more aggressively than had been our won