stability are prone to excess. we must thus remain vigilant against complacency, especially since several important economic challenges confront policymakers in the years ahead. prominent among these challenges in the united states is the pressing need to maintain the flexibility of our economic and financial system. this will be essential if we are to address our current account deficit without significant disruption. besides market pressures, which appear poised to stabilize and over the longer run possibly to decrease the u. s. current account deficit and its attendant financing requirements, some forces in the domestic u. s. economy seem about to head in the same direction. central to that adjustment must be an increase in net national saving. this serves to underscore the imperative to restore fiscal discipline. beyond the near term, benefits promised to a burgeoning retirement - age population under mandatory entitlement programs, most notably social security and medicare, threaten to strain the resources of the working - age population in the years ahead. real progress on these issues will unavoidably entail many difficult choices. but the demographics are inexorable, and call for action before the leading edge of baby boomer retirement becomes evident in 2008. this is especially the case because longerterm problems, if not addressed, could begin to affect longer - dated debt issues, the value of which is based partly on expectations of developments many years in the future. another critical long - run economic challenge facing the united states is the need to ensure that our workforce is equipped with the requisite skills to compete effectively in an environment of rapid technological progress and global competition. technological advance is continually altering the shape, nature, and complexity of our economic processes. but technology and, more recently, competition from abroad have grown to a point at which demand for the least - skilled workers in the united states and other developed countries is diminishing, placing downward pressure on their wages. these workers will need to acquire the skills required to compete effectively for the new jobs that our economy will create. at the risk of some oversimplification, if the skill composition of our workforce meshed fully with the needs of our increasingly complex capital stock, wage - skill differentials would be stable, and percentage changes in wage rates would be the same for all job grades. but for the past twenty years, the supply of skilled, particularly highly skilled, workers has failed to keep up with a persistent rise in the demand for such skills. conversely, the demand for lesser - skilled workers has

in contrast to the typical pattern early in previous business - cycle recoveries, firms have appeared reluctant to take on new workers and have remained focused on cost containment. as opposed to the lingering hesitancy among business executives, participants in financial markets seem very confident about the future and, judging by the exceptionally low level of risk spreads in credit markets, quite willing to bear risk. this apparent disparity in sentiment between business people and market participants could reflect the heightened additional concerns of business executives about potential legal liabilities rather than a fundamentally different assessment of macroeconomic risks. turning to the outlook for costs and prices, productivity developments will likely play a key role. the growth of output per hour slowed over the past half year, giving a boost to unit labor costs after two years of declines. going forward, the implications for inflation will be influenced by the extent and persistence of any slowdown in productivity. a lower rate of productivity growth in the context of relatively stable increases in average hourly compensation has led to slightly more rapid growth in unit labor costs. whether inflation actually rises in the wake of slowing productivity growth, however, will depend on the rate of growth of labor compensation and the ability and willingness of firms to pass on higher costs to their customers. that, in turn, will depend on the degree of utilization of resources and how monetary policymakers respond. to date, with profit margins already high, competitive pressures have tended to limit the extent to which cost pressures have been reflected in higher prices. productivity is notoriously difficult to predict. neither the large surge in output per hour from the first quarter of 2003 to the second quarter of 2004, nor the more recent moderation was easy to anticipate. it seems likely that these swings reflected delayed efficiency gains from the capital goods boom of the 1990s. throughout the first half of last year, businesses were able to meet increasing orders with management efficiencies rather than new hires. but conceivably the backlog of untapped total efficiencies has run low, requiring new hires. indeed, new hires as a percent of employment rose in the fourth quarter of last year to the highest level since the second quarter of 2001. there is little question that the potential remains for large advances in productivity from further applications of existing knowledge, and insights into applications not even now contemplated doubtless will emerge in the years ahead. however, we have scant ability to infer the pace at which such gains will play out and, therefore, their implications for