I would not expect modest changes in the output gap to exert more than a marginal influence on inflation. But the anticipated slower pace of growth will result in an environment in which firms will be less able to pass on increases in costs. One potential source of higher costs comes from the labor market.
I would not be surprised to see a gradual rise in labor costs as workers capture a greater share of the productivity gains of recent years. However, compensation per hour, a measure derived from unemployment insurance tax records, indicates that labor costs accelerated sharply, to a pace of 7-3/4 percent from the second quarter of 2005 to the second quarter of 2006.