Real economic activity has continued to expand at a solid pace. Clearly, the tragedy that hurricanes inflicted on New Orleans and surrounding areas of the Gulf Coast will have major implications for the people and the economy in those regions for a long time. However, for the nation as a whole, employment and industrial production indicators were only briefly disrupted by the hurricanes during the late summer and early fall.

Looking ahead, I expect the favorable performance of the economy to continue.  Most private forecasters expect the momentum from the solid growth in 2005 to continue into 2006.  Although monetary policy has become less accommodative, it will continue to support economic activity.  Because of the lags with which monetary policy affects the economy, monetary policy accommodation over the past year will continue to act as an economic stimulant, though clearly far less so than in the past several years...My own view is that we will see growth in the 3 1/4 to 3 1/2 percent range, which encompasses the consensus estimate.

Growth is on a solid footing, despite this year’s run-up in energy prices and the disruptions of a devastating hurricane season. After a brief pause this fall, employment has resumed expanding at a healthy pace, consumer spending continues to grow briskly, and business investment spending is robust. Granted, housing activity seems to be softening, and at least some potential price level pressures remain...But inflation expectations remain contained, and we at the Fed are well-positioned to resist inflation pressures, should they emerge. So all in all, it is quite a good outlook.

The U.S. economy has delivered a solid performance thus far in 2005. And, despite the disruptions of Hurricanes Katrina, Rita, and Wilma, economic activity appears to be expanding at a reasonably good pace as we head into 2006. However, the positive short-term economic outlook is playing out against a backdrop of concern about the prospects for the federal budget over the longer run. To be sure, the current pace of the ramp-up in spending on defense and homeland security is not expected to continue indefinitely. But, as the latest projections from the Administration and the Congressional Budget Office suggest, our budget position will substantially worsen in the coming years unless major deficit-reducing actions are taken.

 The economy needed to grow faster than potential in order to eliminate the slack labor and capital resources that had built up during the recession in 2001 and early stages of the recovery, which were sluggish...But now, much of the slack has been eliminated. The unemployment rate has fallen to 5 percent; at the Chicago Fed, we think that such a level is roughly consistent with an economy operating at potential. In addition, the capacity utilization rate in manufacturing is only slightly below its historical average. This indicates that there may be some slack remaining in manufacturing, but probably not much. Finally, core inflation has changed little in recent months. Currently we're not seeing the kinds of disinflationary forces that would be associated with a substantial degree of resource slack like we did a couple years ago.

Macroeconomic volatility has declined over the past two decades. Some of this decline appears to have fed through to financial markets in the form of lower risk premiums and higher asset valuations. To some extent, the lack of a clear link between macroeconomic volatility and the level of asset prices in existing research and models should not be a surprise. Explaining asset prices is difficult because they are determined by many complex factors, such as risk aversion, expected future earnings, and expected earnings volatility, which are inherently difficult to measure. A more concrete finding is that the decline in macroeconomic volatility has not led to a decline in asset price volatility. News about corporate earnings appears to have become less volatile, but this factor explains only a small part of the reduction in the volatility of asset prices. Rather, existing research suggests that asset price volatility remains largely a reflection of variation in investors' discount rates rather than of changes in forecasts of fundamentals. On a micro level, financial innovations and new types of market participants appear to have led to greater market efficiency and liquidity.

The longer-term prospects for the U.S. economy remain favorable. Structural productivity continues to grow at a firm pace, and rebuilding activity following the hurricanes should boost real GDP growth for a while. More uncertainty, however, surrounds the outlook for inflation.

Looking ahead, it’s my belief that—despite the effects of the hurricanes—the most likely path of the economy for the next several quarters is ongoing respectable growth of GDP, employment, and income. That pattern suggests to me that we should continue to move toward a neutral setting for monetary policy. The Fed already has moved interest rates a long way toward a more normal level consistent with sustainable growth. By most conventional measures, however, policy is still accommodative.

With regard to economic activity, my best guess is that the economy retains a good deal of forward momentum and that the evolution over time of the balance between aggregate demand and potential supply may not be greatly affected by the hurricanes and further rise in retail energy prices. In particular, the factors that were supporting the growth of activity through the first two-thirds of the year are still in place: Market interest rates remain relatively low and credit spreads narrow; underlying growth of productivity--the ultimate source of long-run gains in incomes and living standards--appears to be appreciable; and the rapid rise in house prices, which persisted through at least the first half of the year, has given households a reservoir of housing wealth that they can draw on to support spending.

In sum, I see risks on both sides of my expectations that the growth of economic activity will slow modestly on balance over the next year or so, leaving the economy producing at about its sustainable potential. But unless activity slows unexpectedly, and after the rise in retail energy prices, the risks may be skewed a little toward the upside on inflation. Because the economy is producing at a reasonably high level and activity is most likely on a solid upward track, my focus at this time is naturally on keeping inflation contained.

In this environment of somewhat faster growth in aggregate spending and greater upward pressure on prices, the Federal Open Market Committee (FOMC) raised its target for the federal funds rate to 3-1/2 percent in early August. At the same time, the Committee reiterated its belief that, with the appropriate monetary policy actions, the upside and downside risks to the outlook for sustainable economic growth and price stability were roughly equal and that the removal of monetary accommodation could proceed at a "measured pace." Thus, before the hurricanes, the outlook was relatively benign: continued moderate economic growth accompanied by little change in the underlying pace of core inflation.

Despite the uncertainties that exist, I believe that these unfortunate events [Hurricanes Katrina and Rita] do not pose a persistent threat to national economic activity.  My overall assessment is that the national economy, while not without challenges, is in reasonably good shape and that conditions should allow for solid growth in the future.  In context, I believe that the Federal Reserve should continue to focus on having a neutral monetary policy which reflects its commitment to price stability.

Before the hurricanes struck, the economy was clearly on a sustainable path of expansion.  While the recent disruptions and dislocations in the gulf may slow the rate at which the economy grows for a time, I believe the expansion is strong enough to withstand them.

Before Katrina, the national economy was in pretty good shape, with most signs pointing to fairly strong growth. GDP had expanded by 3 percent or better for nine straight quarters. Aside from manufacturing, the job situation also looked bright...[And] despite rising prices for oil, natural gas and other energy supplies, inflation remained relatively tame...How does Katrina alter the outlook? The truth is, we do not really know.

Data during the late spring and early summer suggested that aggregate demand was stronger than had been previously thought, implying greater momentum in spending. Moreover, the data showed a drop in the pace of inventory accumulation, especially for autos. Therefore, most forecasters were predicting fairly rapid growth for the second half of the year, as firms rebuild their inventories, with a return to trend-like growth in 2006.