The intensification of geopolitical risks makes discerning the economic path ahead especially difficult. If these uncertainties diminish considerably in the near term, we should be able to tell far better whether we are dealing with a business sector and an economy poised to grow more rapidly--our more probable expectation--or one that is still laboring under persisting strains and imbalances that have been misidentified as transitory.

The limited evidence since the November easing has supported our view that the U.S. economy has been working its way through a soft patch. And the patch has certainly been soft. The labor market has remained subdued, as businesses apparently have been reluctant to add to payrolls. The manufacturing sector remains especially damped, and nonresidential construction has trended lower. By all reports, state and local governments continue to struggle with deterioration in their fiscal conditions. Oil prices have recently risen and, not least, the economies of most of our major trading partners have shown little vigor.

Considerable uncertainties--about the progress of the adjustment of capital spending and the rebound in profitability, about the potential for additional revelations of corporate malfeasance, and about possible risks from global political events and terrorism--still confront us.

Despite the disruptions engendered by the terrorist attacks of September 11, the typical dynamics of the business cycle have re-emerged and are prompting a firming in economic activity. The recent evidence increasingly suggests that an economic expansion is already well under way, although an array of influences unique to this business cycle seems likely to moderate its speed.

Some moderation in the pace of spending was necessary and expected if the economy was to progress along a more balanced growth path..The adjustment occurred much faster than most businesses anticipated, with the slowdown likely intensified by the rise in the cost of energy that until quite recently had drained businesses and households of purchasing power.

The period of sub-par economic performance, however, is not yet over, and we are not free of the risk that economic weakness will be greater than currently anticipated, and require further policy response. That weakness could arise from softer demand abroad as well as from domestic developments. But we need also to be aware that our front-loaded policy actions this year coupled with the tax cuts under way should be increasingly affecting economic activity as the year progresses.

Although the sources of long-term strength of our economy remain in place, excesses built up in 1999 and early 2000 have engendered a retrenchment that has yet to run its full course. This retrenchment has been prompt, in part because new technologies have enabled businesses to respond more rapidly to emerging excesses. Accordingly, to foster financial conditions conducive to the economy's realizing its long-term strengths, the Federal Reserve has quickened the pace of adjustment of its policy.

Nonetheless, in the face of the energy price spike and the erosion of optimism in financial markets, consumer confidence, or sentiment, appears to be holding up reasonably well to date, though there have been some mixed signals of late...

...[I]n an economy that already has lost some momentum, one must remain alert to the possibility that greater caution and weakening asset values in financial markets could signal or precipitate an excessive softening in household and business spending.

I'm not unduly concerned about either {inflation or growth} yet.  It is certainly true that we are seeing now quite clear signs of moderation in demand in the economy.  Demand growth really seemed to be excessive a year ago.  A slowing is a healthy development.  We don't want it to proceed too far, but my view, I'm not not unduly concerned about what has happened, although I am watching incoming data as closely as I can.

I'm not unduly concerns about what I can see {on inflation}, but I would have to tell you, it's moving in the wrong direction, especially in the service sector.  I'm certainly not panicked yet, none of us are unduly alarmed, but this is our main job.

We cannot yet be sure that the slower expansion of domestic final demand, at a pace more in line with potential supply, will persist. Even if the growth rates of demand and potential supply move into better balance, there is still uncertainty about whether the current level of labor resource utilization can be maintained without generating increased cost and price pressures. As I have already noted, to date costs have been held in check by productivity gains. But at the same time, inflation has picked up--even the core measures that do not include energy prices directly. Higher rates of core inflation may mostly reflect the indirect effects of energy prices, but the Federal Reserve will need to be alert to the risks that high levels of resource utilization may put upward pressure on inflation.

With foreign economies strengthening and labor markets already tight, how the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process.

But, after eight years of economic expansion, the economy appears stretched in a number of dimensions, implying considerable upside and downside risks to the economic outlook. The robust increase of production has been using up our nation's spare labor resources, suggesting that recent strong growth in spending cannot continue without a pickup in inflation unless labor productivity growth increases significantly further. Equity prices are high enough to raise questions about whether shares are overvalued. The debt of the household and business sectors has mounted, as has the external debt of the country as a whole, reflecting the deepening current account deficit. We remain vulnerable to rapidly changing conditions overseas, which, as we saw last summer, can be transmitted to U.S. markets quickly and traumatically.