To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.

The rise in commodity prices presents particular challenges for monetary policy because such increases both add to near-term inflationary pressures and damp demand. A tendency for increases in commodity prices to become a factor in ongoing pricing and wage-setting more generally would be a worrisome development that would over time tend to undermine economic welfare.

In the near term, headline inflation is likely to continue to be boosted by the direct effects of the recent increases in the prices of energy and food. If, as futures markets suggest, those prices level off later this year, prospects seem reasonably good for headline inflation to move back in line over time with core inflation. And I expect core inflation to ease off slowly as commodity prices level out and as economic slack creates competitive conditions that inhibit increases in labor costs and prices

We estimate ... that every $10 increase in the cost of a barrel of oil reduces the real GDP somewhere between two-tenths and perhaps as much as a half a percentage point.

At a conservative level, that means that we have taken at least another percentage point off on a national scale in terms of real gross domestic product.

As reported by Reuters

There still is growth in the world economy, even if we slow down. It's difficult for me to see a supply response that will feed into that demand to relieve all the price pressures we see on oil.

As reported by Reuters

This grim trio—the credit crunch, the deflating housing bubble, and the rising price of commodities—has combined to weigh heavily on demand by both consumers and businesses.

Under present circumstances, judging future changes in commodity prices is obviously an important part of any inflation forecast. As I noted, future markets generally are expecting these prices to flatten out and remain at around today’s very high levels. If this happens, then the effects of commodity prices on inflation will dissipate. In order to continue to put upward pressure on inflation—which, after all, is the rate of change of prices—commodity prices would have to do more than remain at today’s high levels. They would need to keep on rising.

While this seems unlikely based on experience in recent decades, we can’t rule out this possibility. Futures markets have been expecting a leveling out of most commodity prices for several years now, and they keep being surprised by ongoing increases. As I mentioned before, in part, this could reflect growing supply limitations on some commodities, especially oil. However, there also is the possibility that commodity prices could fall in the future as the economic weakness in the U.S. and slowing in Europe could spread to the rest of the world, reining in demand for commodities. I mentioned before that there is an usually wide spread in Blue Chip forecasts for real GDP growth—well, not surprisingly, the dispersion for inflation forecasts is also unusually large at the present time, perhaps reflecting these divergent possibilities.

Inflation was disappointing as well last year. The price index for personal consumption expenditures rose by 3.6 percent during 2007, compared to 2.3 percent the year before. Rapid increases in food and energy prices were the obvious culprits, but that provides little comfort to this central banker. The Federal Reserve is responsible for keeping total inflation low and stable—including food and energy prices. While the effects of unexpected commodity price increases are difficult to offset rapidly, an appropriate monetary policy would ensure that such shocks even out over time and do not impart a persistent inflation bias—either up or down.

 [R]ising energy prices have sapped consumer and business spending. Because so much of our oil is imported, an increase in oil prices effectively acts as a tax on consumer and business spending.

Earlier, I mentioned the potential impact of the recent financial market disruptions on growth. Indeed, concern with the effects of these disruptions and, in particular, the possibility they could lead to a severe credit contraction was the principal motivation for the aggressive easing of monetary policy by the Federal Reserve over the past several months. ... Although credit conditions have tightened considerably in recent months and some markets for asset-backed securities have shut down, we have not seen as large a credit crunch as some anticipated. Indeed, outside of some mortgage markets, consumers and businesses with strong credit histories have continued to have access to credit on reasonable terms. Consequently, in my opinion, financial markets disruptions, while noteworthy, are not the major story behind the recent weakness in economic activity. Energy price increases and housing dominate this slowdown.

[T]here are reasons that suggest the economic slowdown will be short-lived. Part of the pickup in growth will likely come from the tax cuts that are going into effect currently, part from the monetary policy stimulus provided by low interest rates and part from a boost to exports from the lower dollar. Forecasters also see moderation in energy and food costs later this year, which would provide a boost to growth but also lead to lower inflation pressures.

As I indicated earlier, we are also seeing signs of stabilization in financial markets, with improved liquidity and more transactions. Still, many markets are not functioning normally, and it will take additional time for the damage to be assessed and repaired.

As to monetary policy, the current accommodative stance should be sufficient to cushion the economy from a deeper slowdown and the risks that financial disruptions could spill over to the broader economy. As the economy recovers and credit conditions improve, however, it will be necessary for the Federal Reserve to remove the policy accommodation in a timely manner. How fast this occurs will depend on whether inflation pressures moderate or intensify in the period ahead.

Energy has systematically begun to increase at a faster rate, food is systematically increasing, therefore the rationale for taking it out of the total (consumer price index) and looking at the core is less compelling. And so I am looking, and I think others are, at the total CPI, or (personal consumption expenditures) number as much as, if not more, now, than the core.

From Q&A as reported by Reuters

That's not noise.That's a signal.

On oil prices reaching $120 a barrel and other energy demand trends.

Will the U.S. slowing down really damp the price of oil, or the price of food, rice, or flour, cornmeal, the price of steel? … It’s not clear to me that a mild slowdown will put a dent in price pressures domestically. Obviously if you have a tail risk of a very severe global slowdown, then yes, I can see that. I don’t see that in the cards at least from my limited perspective. If you think in closed-economy terms, that’s more likely to obtain. If you think in global terms, it is less likely to obtain unless the whole world slows down.

Over the past year, inflation has been elevated by rising food, energy and other commodity prices and declines in the value of the dollar that have boosted import prices. However, several developments suggest that inflation is likely to moderate over the next couple of years. For example, broad measures of compensation have expanded quite modestly over the past year, and productivity growth has been fairly robust. In addition, futures markets point to a leveling out of energy and other commodity prices. Furthermore, the weakening in economic activity should put somewhat greater downward pressure on inflation going forward.

The Federal Reserve cannot, however, be complacent about inflation. Most survey measures of longer-run inflation expectations have remained reasonably well behaved. But measures of inflation compensation derived from the differential between nominal and real Treasury yields have moved up for the period of five-to-ten years ahead. Such measures are an imperfect indicator of inflation expectations, because they are affected by inflation risk and illiquidity. Nevertheless, these movements highlight the risk that our attempts to deal with problems in the real economy could lead to higher inflation expectations and an erosion of our credibility.

There is no evidence that is occurring, "but that's a danger," she said, noting that inflation is due to negative supply shocks to the economy, not the result of "everyone drinking the punch."

...

She said she continues to view core CPI as a better "forward-looking" measure of inflation, but only if one believes, as futures markets are predicting, that food and energy prices will eventually stabilize. And on that score futures markets in recent years have been "wrong, wrong and wrong." However, policymakers cannot claim to have achieved price stability "unless it shows up in the headline number," she said.

From Q&A as reported by Market News International