Although the rate of pass-through of higher energy and other commodity prices to core consumer price inflation appears to have remained relatively low in the current episode--reflecting the inflation-fighting credibility built by the Fed in recent decades the cumulative increases in energy and commodity prices have been large enough that they could account for some of the recent pickup in core inflation.

As yet, these [inflation] expectations measures have remained within the ranges in which they have fluctuated in recent years and inflation compensation implied by yields on government debt has fallen back somewhat in the past month. Nevertheless, these developments bear watching.

In the short run, [energy] prices are likely to remain high in an environment of strong world economic growth and a limited ability to increase energy supplies. Moreover, prices are likely to be volatile in the near term, given the small margins of excess capacity to produce crude oil or natural gas that traditionally have buffered short-run shifts in supply and demand.

Energy prices have moved up considerably since the end of 2002, reflecting supply and demand factors. In the short run, prices are likely to remain high in an environment of strong world economic growth and a limited ability to increase energy supplies. Moreover, prices are likely to be volatile in the near term, given the small margins of excess capacity to produce crude oil or natural gas that traditionally have buffered short-run shifts in supply and demand. However, in the long run, market forces will respond. The higher relative prices of energy will create incentives for businesses to create new, energy-saving technologies and for energy consumers to adopt them.

Headline measures of inflation of late have been bothersome, with higher oil prices contributing to much of the run-up in those broad readings. Core inflation, which excludes volatile food and energy costs, has moved into the upper end of—or beyond—the range I consider acceptable over time.

The new participants, investors and speculators, to the world’s two trillion dollar-a-year oil market are hastening the adjustment process that has become so urgent with the virtual elimination of the world supply buffer. With the demand from the investment community, oil prices have moved up sooner than they would have otherwise.

Hypothetically, if we still had the 10 million barrels a day of spare capacity that existed two decades ago, neither surges in demand nor temporary shutdowns of output from violence, hurricanes or unscheduled maintenance would be having much, if any, impact on price. Returning to such a level of spare capacity appears wholly out of reach for the foreseeable future, however.

Aside from Saudi-Aramco, few, if any, of national oil companies which own most of the world’s proved oil reserves are investing enough of their surging cash flow to convert the reserves into crude oil productive capacity. Only Saudi-Aramco appears sufficiently concerned, at least publicly, that high oil prices will reduce the long term demand for oil, which could significantly diminish the value of Saudi Arabia’s – or indeed, any country’s –oil reserves.

To date, it is difficult to find serious erosion in world economic activity as a consequence of sharply higher oil prices. Indeed, we have just experienced one of the strongest global economic expansions since the end of World War II. The United States, especially, has been able to absorb the huge implicit tax of rising oil prices so far. However, recent data indicate we may finally be experiencing some impact.

Futures markets imply that oil prices are not expected to continue rising.  The realization of that outcome would reduce one source of upward pressure on inflation.  However the volatility of these and other commodity prices is such that possible future increases in these prices remain a risk to the inflation outlook.

Higher energy prices do not necessarily imply a persistent rise in inflation. Suppose energy costs stabilize, as the oil futures market predicts. Once businesses adjust their own prices to cover the higher costs, prices would not have to rise faster than increases in the cost of other inputs, and overall inflation would return to its earlier rate. Thus, the energy price increases we have seen to date should result in a one-time increase in prices and a temporary rise in the core inflation rate, not a sustained higher rate of core inflation. Indeed, this pattern can be seen in the slightly lower range for most core inflation forecasts in 2007 compared to 2006.

Energy prices have surprised us over the past few years, in terms of the extent of the rise in prices, the increase in volatility, and the limited negative effects to date on global economic growth. Our capacity to project future energy prices has proven to be very limited, as has our ability to convincingly ascertain the extent to which temporary supply factors, rather than an unrecognized strength in global demand, accounts for the energy price trajectory we've witnessed recently.

To be sure, most forecasters are expecting the overall pace of economic activity to moderate to a more sustainable pace in coming quarters as housing markets gradually cool and the delayed effects of higher interest rates and energy prices temper domestic demand. However, with economic activity abroad expanding at a solid pace, export sales should provide some support for domestic production.

Despite volatility in energy prices, we used to think that oil would settle back over time to around $25–$30 a barrel. But our experience for the past two years has changed that expectation, at least in the view of futures markets

With oil prices persistently above $70 a barrel, households and businesses face new costs that must be absorbed, offset, or passed along if possible. Although difficult to measure, these higher energy costs have forced households to reallocate spending and could dampen consumer spending in the future.