In recent years, ... the circumstances of the 1973 oil shock have not been repeated. The economy has not been overheated; the economy is more energy-efficient so the impact on supply of oil shocks has been moderated; and the more severe spikes in the oil price such as in summer 2006 have been recognized as transitory in nature. In these circumstances, monetary policy is in a much better position to support aggregate demand in the face of oil shocks without endangering medium-term price stability. This state of affairs has been emphasized by the Federal Reserve Chairman in his discussion of the effect of oil shocks. 

The economy has performed well despite a near tripling of crude oil prices since December 2001. In years past, an energy price shock of this magnitude was typically associated with a substantial increase in inflation and a sharp recession.

Two things are different about energy price increases this time. One is that the increases were primarily a consequence of a booming world economy, which raised energy demand rather than a supply shock. Second, monetary policies here and in most other countries have done a fine job of anchoring inflation expectations.

When we try to model energy pass-through econometrically, the results indicate that a break occurred in pricing patterns in the early 1980s: Pass-through is clearly evident before 1980 but it is difficult to find thereafter. I suspect this pattern has something to do with the monetary policy reaction to those shocks and its effect on inflation expectations. In the 1970s, monetary policy not only accommodated the initial shocks but also allowed second-round effects to become embedded in more persistent increases in inflation. Since the early 1980s, the pass-through to core prices has been limited or non-existent, at least in part because households and firms have expected the Federal Reserve to counter any lasting inflationary impulse that they might produce. This result reinforces the need today to keep inflation expectations well anchored. In addition, movements in relative oil prices were more persistent before 1980 and less persistent after--until recently. After 1980, households and firms probably expected deviations of energy prices from long-run averages to be largely reversed and saw less reason to try to adjust wages and prices in response to what they viewed as transitory changes in energy costs.

Back in 1968, Milton Friedman warned economists and policymakers not to try to stimulate economic growth at the cost of "just a little more" inflation.  He predicted that people would come to anticipate that little bit of extra inflation, and then would change their behavior in various ways. The end result would be slower economic growth and ever-higher inflation. In effect, Friedman was warning policymakers not to treat inflation as a static concept, but to appreciate the interdependence between inflation and inflation expectations.

Unfortunately, the economic events of the 1970s bear out Friedman's warning. Households and businesses did adjust their behavior to minimize the costs they faced from rising inflation. And once inflation expectations became unglued, we watched with dismay as the costs arising from inflation expectations took a huge toll on our resources. The economy spiraled into "stagflation" - an environment of worsening economic performance and higher inflation.

The problem with financial market indicators is that asset prices respond to any number of risks, not just inflation.   In a world that is always confronting and evaluating risks, disentangling the inflation risk from all the other risks is a very imperfect science. Nevertheless, financial market indicators are proving to be a useful yardstick for monitoring inflation expectations...

You might think that a better way to gauge inflation expectations would be to simply ask people their views on inflation. In fact, there is a survey that does just that. Once a month, the University of Michigan interviews about 500 households around the nation, asking people how much they think prices will rise in the next 12 months and over the next 5 to 10 years. Here, too, there are some problems with interpreting the raw data. For one thing, households' beliefs about future inflation are typically much higher than the actual inflation rate.

Also, investigations into the survey data have revealed some fascinating patterns. For example, people are likely to report their inflation predictions in terms of whole numbers, and particular whole numbers at that. It turns out that people are far more likely to report that they expect 0, 3, or 5 percent inflation than 1, 2, or 4 percent.

Appreciating this distinction helps one better understand ideas like "core" inflation, which are useful metrics for the central bank, and perhaps only the central bank, to monitor. These core inflation measures, most commonly constructed as an aggregate price statistic less food and energy prices, attempt to strip away the most volatile of the relative price movements that may temporarily cause the aggregate price measure to fluctuate in a way that is not symptomatic of a persistent change in the purchasing power of money.

When you get right down to it, we really know very little about how people form their inflation expectations.  To what extent are expectations based on past inflation experience versus looking into the future? Do people scour all of the available data to predict inflation, or do they just consider the information most readily available to them? And, perhaps most important, how do people act on the inflation expectations that we measure through the household surveys?

There is much at stake in the answers to these questions. We might discover important differences between household survey information and financial market data. We may also find an answer to one of the great questions - and obstacles - in the monetary policy process. Namely, are inflation expectations responsible for the long time it takes for monetary policy actions to show up in the inflation data?

Understanding what lies behind our measures of inflation expectations could greatly enhance the design and conduct of monetary policy. For example, it could help us understand what types of institutional arrangements and communication policies help the central bank retain credibility for meeting its price stability objective, even when large and persistent relative price changes ripple through the inflation data.

To that end, unlocking some of the mysteries about inflation expectations may help central banks decide whether, and how, to incorporate a numerical inflation objective into the monetary policy process.  Some central banks have used these numerical objectives as a tool to help anchor inflation expectations. Economists refer to a numerical inflation objective as a "commitment device," that is, a means for holding a central bank's feet to the fire. That may be so. But whether or not there is an explicit numerical objective, anchoring inflation expectations requires a central bank to keep inflation low and stable, to reinforce its commitment to price stability, and to clearly communicate its policies in pursuit of that commitment

In response to the question:  "Are you worried that the Fed could lose its inflation-fighting credibility?"

I'm very concerned.  And it's not a big black or white thing, losing our credibility.  I think that everyone believes we wouldn't let the '70s happen again.  But an erosion from 1.5%, to let inflation, core inflation, drift from 1.5% up to 3%, I'm not sure people are convinced we wouldn't let that happen, and I think we ought to take action to prevent that notion from becoming lodged in peoples' minds.

A lot of our contacts within the district since the beginning of the year, since the spring, have been reporting that they're increasingly able to pass along cost increases, energy cost increases in the form of high prices — something we weren't seeing a year ago.

Recent evidence suggests that there has been much less passthrough in the past twenty-five years than there was back in the 1970s, when inflation got out of control in the face of soaring energy prices. If it's true that there's only a very small passthrough of higher energy prices to inflation currently, then that raises the concern that something more fundamental is pushing up inflation. Unfortunately, at this point, it's too soon to untangle these alternative interpretations.

Six months ago...the energy price surge had led some observers to expect to see those prices pass through to a broad range of prices of goods and services, much like what happened in the 1970s. But that hasn’t happened. Core inflation has been low and relatively steady in the last several years. Our preferred inflation measure, the price index for core personal consumption expenditures, has risen 1.8 percent over the last 12 months. Despite rising energy prices, core inflation actually fell slightly last year, since the core price index had risen 2.2 percent in 2004. Similarly, we are not seeing any sign of rising inflation in the most recent data.

Econometric evidence suggests, however, that the pass-through of energy prices to core inflation has dropped by more than would be implied by the decline in energy intensity...

Although many factors could have led to these results, a likely explanation is that inflation expectations have become better anchored. In the 1970s, monetary policy unfortunately allowed large increases in energy prices to have a persistent effect on inflation, a policy that undercut the Fed's credibility and caused long-run inflation expectations to be more volatile.

In principle, the problem of inflation could be reduced by the practice of indexing dollar payments such as interest and wages to the price level, but people seem to find indexing costly and avoid it when they can. It is interesting and instructive, for example, that the indexation of wages to prices in labor contracts has always been quite limited in the United States; some indexation was used during the high-inflation 1970s but the practice has been substantially reduced since then. Moreover, some countries that adopted indexing during high-inflation periods, such as Brazil and Israel, largely abandoned the practice when inflation receded.

Today, we see oil prices going up, but we see very little response in wages and prices. We see overall inflation relatively stable. We don't have to have the same aggressive monetary policy response we had in the '70s. And that's a direct benefit of the improvement in inflation expectations that we've gotten in the last 30, 35 years.

Immediately following Hurricane Katrina, as the magnitude of the effects on Gulf Coast energy production became clear, many observers came to fear that the resulting sharp increase in energy prices might lead to a broader increase in inflation, and perhaps even recessionary forces. These observers appeared to be reasoning by analogy to the 1970s, but I believe that analogy is mistaken. Inflation expectations were unanchored in the 1970s, the credibility of the Federal Reserve was low, and people expected the Fed to allow energy price shocks to feed through to overall inflation. The Fed often accommodated that expectation by preventing short-term real interest rates from rising. In fact, at times we kept nominal rates from rising as fast as inflation and thus provided further monetary stimulus. The Fed was then forced to raise rates dramatically to bring inflation back down, and in the process induced an economic contraction, exacerbating the real effects of the oil price shocks. Thus, the proper lesson from the 1970s is not that energy price shocks induce major recessions or cause widespread inflation; it is that monetary policy that reacts to energy price shocks by accommodating the rise in inflation can induce major recessions. Monetary policy should respond to energy shocks by remaining focused on price stability. That way, the economy can respond to energy price shocks the way it should — the relative price of energy increases, but core inflation remains anchored.