It looks like Eurogamer got a chance to test it, and it went like this:
Peter Molyneux: Absolutely, all of that works. We're combining all that together to make you really believe that he understands what you say.
Let's try an experiment. When a human voice says something funny, there's a different tone in the voice. Even though Milo's not trained to recognise your voice, if you say something funny to him, he should recognise it as something amusing. Try it now.
Eurogamer: Tell him a joke, you mean?
Peter Molyneux: Yeah.
Eurogamer: OK. Milo?
Milo: [Looks up, smiles and nods]
Eurogamer: Bloody hell. Er, OK. A Times New Roman walks into a bar. The barman says, 'We don't serve your type.'
Milo: [Giggles]
Eurogamer: Bloody hell.
Peter Molyneux: Now, he didn't really understand every word you said, but from the tone of your voice he guessed you were telling a joke.
Eurogamer: But I put it to you, Peter, that was not a very good joke. So the fact he laughed at it demonstrates a serious flaw within the software.
Peter Molyneux: Well, that wasn't a real laugh. That was a polite giggle. Let's move on. The game is called Milo and Kate and you play through a story. There is another character called Kate. Kate is a dog.
For the whole interview:
http://www.eurogamer.net/articles/e3-project-natals-molyneux-and-milo-interview
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