What is very important is that the central bank not control inflation in the very short run, or try to hit very narrow ranges. And the reason for this is that a lot of movements in underlying inflation have to do with things that are out of the monetary policy control. What is particularly important in this regard is supply shocks, for example, sharp rises in energy prices.

From audience Q&A, as reported by Market News International and Reuters

Credibility accounts for why inflation appears generally to have become less persistent. Households and firms believe that such shocks will not be allowed to feed into further increases in inflation, so inflation expectations have become better anchored. Indeed, much research documents that movements in energy prices have had far smaller effects on core inflation since the mid- 1980s, and the most compelling reason for this shift is the credibility of monetary policy.

I believe there're longer term tectonic, structural forces at play. If they were temporary I'd be less concerned about them. I'm more concerned because I think they have to do with demand-pull as I mentioned earlier coming from the world at large as it grows and the ability of supply to respond. I'm concerned also by the way that the futures markets for oils have not proven to be very good indicators of future oil prices. So if we have these sustained high price levels... if gasoline at the tank goes as it has up 8 cents two weeks ago, 9 cents this past week and keeps rising, no doubt it will feed into inflationary expectations of consumers, and then business women and men who run businesses, and that's what we have to guard against.

Although the danger is real, it is also true that oil futures prices for contracts several years ahead do not suggest continuing increases in oil prices of the magnitude observed over the past five years. That was also true five years ago—the futures market turned out to be wrong. However, my view is that policymakers should rely on the judgment of the markets unless we have solid evidence that the markets are wrong. My personal experience is that, although the markets obviously can be wrong, I have no confidence that my own judgment on something like oil prices will be systematically more accurate.

The softer labor market, together with factors including higher energy prices, lower equity prices, and declining home values, seem likely to weigh on consumer spending in the near term. On the other hand, growth in U.S. exports should continue to provide some offset to the softening in domestic demand, and the recently approved fiscal package should help to support household and business spending during the second half of this year and into the first part of next year.
 

When energy prices go up, it pushes inflation up, and we face a choice whether to counteract that or not. When the futures market's telling you that they're going to flatten out, it doesn't look like there's as much to counteract. But we've been surprised on the positive side by energy prices for four years in a row now. At some point you just have to ask the question of whether the futures markets are a reliable guide and whether we need to do more to offset the effect of energy prices on the overall level of inflation.

From press Q&A as reported by Market News International

I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.

I am also troubled by the lengthy divergence we've seen between overall and core inflation. Some of you may recall that core inflation was devised in the 1970s to filter out some of the more volatile consumer prices to get a better read on inflation trends. For several decades, core inflation seemed to work well due to the fact that food and energy prices had no clear trend relative to the overall price level. In the last few years, though, overall inflation has been persistently above core inflation, and few observers expect oil prices to go back below $20 per barrel. Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation. Going forward, markets expect oil prices to back off slightly from their current level, and I hope they are right this time.

Of course, I know that our economy is confronting a number of challenges as the new year begins. The residential real estate market still appears to be in freefall. In addition, oil prices have risen, and housing and equity prices have fallen. These factors are restraining the economy beyond the housing sector.

Since August, however, the inflation picture has deteriorated. In September and October, the overall PCE price index rose at a 3.3 percent annual rate, and the core index rose at a 2.6 percent rate. Judging by the closely related consumer price index, the numbers for November will be even worse. Now these numbers do display transitory swings, so I wouldn't extrapolate them forward indefinitely. Still, I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.

I am also troubled by the lengthy divergence we've seen between overall and core inflation. Some of you may recall that core inflation was devised in the 1970s to filter out some of the more volatile consumer prices to get a better read on inflation trends. For several decades, core inflation seemed to work well due to the fact that food and energy prices had no clear trend relative to the overall price level. In the last few years, though, overall inflation has been persistently above core inflation, and few observers expect oil prices to go back below $20 per barrel. Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation. Going forward, markets expect oil prices to back off slightly from their current level, and I hope they are right. If energy prices fail to decline, monetary policy decisions will be that much more difficult in 2008.

[H]igher oil prices caused by productivity gains have a much different effect on the economy than oil supply shocks. A productivity shock originating in the U.S. will boost our economic output, and the expansion will pull up the price of oil. If monetary policy holds the growth of nominal GDP constant, this will result in a reduction of inflationary pressures. If China or India or some other country is expanding rapidly and it is the country's oil consumption that is increasing, driving up prices, that surge in productivity can yield spillovers for the U.S. in the form of lower import prices and technological gains. As long as this continues, we can expect to see an expansion of output and lower overall prices, even as the world price of oil rises. A vicious cycle is, in a sense, almost transformed into a virtuous cycle.

With each uptick in energy prices, I ask whether it is supply or demand that is making prices rise. Supply disruptions are cause for concern, but growth in demand is not as worrisome. Most likely, energy prices will continue to be volatile; it is the nature of the beast. The same goes for food prices.

World energy demands are likely to continue to grow rapidly, as economic growth in China and India has developed substantial momentum. We should hope that growth will take hold in Africa and in Middle Eastern countries. If it does, rapid economic development in those areas will add further to growth in world energy demand.  Whether higher growth in the world economy will continue to push energy prices up will depend on developments in energy supply. There are many promising technologies that in time could make important contributions to energy supplies.

Over the past four years, we have seen none of the macroeconomic complications of the early energy price shocks. An important part of the difference this time is that the recent trend in relative energy prices has been driven by rapidly increasing world demand for energy.  Figure 7 shows energy consumption in four major economic areas: the United States, Europe, Japan and China plus India.(1) The latest data available are for 2004. Between 2002 and 2004, primary world energy consumption increased 9 percent...

However, energy markets work! The real price increases have provoked a response in production sufficient to accommodate the higher demand. World production of primary energy increased 9.1 percent from 2002 through 2004. The price mechanism in world energy markets is alive and functioning well to increase total production and to allocate available supply among the existing and emerging sources of demand.

Similar logic explains the finding that inflation is less responsive than it used to be to changes in oil prices and other supply shocks. Certainly, increases in energy prices affect overall inflation in the short run because energy products such as gasoline are part of the consumer's basket and because energy costs loom large in the production of some goods and services. However, a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent "wage-price spiral." With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices. A related implication is that, if inflation expectations are well anchored, changes in energy (and food) prices should have relatively little influence on "core" inflation, that is, inflation excluding the prices of food and energy.

Well, in the short term, the demand for oil is inelastic, that is, it doesn't respond much to price changes. And so, when there are fluctuations in availability of oil, you get these big spikes and movements in oil prices. And we've seen quite an increase in oil prices over the last few years, as you know.

Over the longer term, higher oil prices actually have a benefit, which is they encourage conservation and they encourage alternative supply sources.

Coal, of course, is actually a very promising source. It's, of course, a traditional source of energy, but assuming we can find ways to address the environmental implications, and there are many promising directions there, coal could be a very big part of our energy diversification in the future.

So my expectation is that as long as the markets are allowed to work, together with some support for research and development from the government, together with clear and effective regulation, that we will solve our energy problems and that that solution is going to come not just from one single magic bullet, it's going to come from a wide variety of different alternative sources, including, I think, coal.

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.