While energy is increasingly cited as a justification for price increases, many businesses—especially goods producers—can’t or won’t pass along higher costs. In part, that’s because global competition helps keep prices down and thus induces businesses to improve efficiency to maintain profits. The result is higher productivity, which helps to offset increased costs, including energy.

My staff and I have pored through reams of data and talked to many business contacts to try to determine the extent of energy cost pass-through. We’re finding the impact on transportation costs is large, and the spillover effect of higher energy costs affects various industries in different ways.

Rising energy prices pose risks to both economic activity and inflation. If energy prices stabilize this year, even at a high level, their adverse effects on both growth and inflation should diminish somewhat over time. However, as the world has little spare oil production capacity, periodic spikes in oil prices remain a possibility.

Although pass-through from energy and commodity price increases to core inflation has thus far been limited, the risk exists that strengthening demand for final products could allow firms to pass on a greater portion of their cost increases in the future.

In particular, we do expect to see a slight slowing in growth, perhaps a couple tenths, this year and next, associated with the higher oil prices and their effects on consumer spending.  And we are very aware of that and are paying attention to those developments.

So far, at least, the near doubling of energy prices has not been reflected in slower consumer spending—possibly because of a stimulatory offset from rising house prices. My assumption, based on the forecasts embodied in futures markets, is that energy prices will stabilize around their current levels. If so, the negative effect on spending should dissipate over 2006, and, as it does, this would actually contribute to higher overall economic growth.

Apparently, we haven't had much in the way of pass-through from past increases in energy and commodity prices to core inflation yet, but I wouldn't be surprised if some modest amount were evident in the next couple of quarters.

We at the Chicago Fed think that after a strong rebound in the first quarter of 2006, real GDP growth will average somewhat above three percent over the next couple of years. We expect that the unemployment rate will change little from its current level and that inflation will remain contained. However, inflation currently is near the upper end of the range that I feel is consistent with price stability. As such, I believe monetary policy must be vigilant. We need to make sure that increases in resource utilization or prices of energy and other commodities do not add to inflationary pressures or increase inflation expectations.

The world economy is very important for certain types of goods. It does nothing, for example, for energy supplies domestically. Think about electricity, the electricity we produce here is not imported from anywhere, maybe a little bit from Canada and Mexico. So there are certain areas of industrial output that are heavily dependent only on local supplies.

Other areas like automobiles would be an obvious example where you can import a lot of goods from abroad. So it varies. Globalization has an important for some parts of the economy but not for others.

In the case of the crude oil market, some observers have attempted to attribute at least part of the increase in oil prices over the past few years to the activities of hedge funds and other speculative traders.  The apparent increased participation of these traders in the market, however, does not mean that their actions are actually responsible for the price run-up.  In fact, increases in oil prices probably encouraged the entry of speculative investors in the market. It may also be the case that these market participants have added liquidity to the market and have faciliated the price discovery process at a time when the balance of supply and demand in the physical oil market has undergone significant change.

Overall, the fundamentals appear sufficient to support continued economic expansion. Underlying productivity growth remains strong, the financial positions of households and businesses remain conducive to spending, and, if we have no further run-up in oil prices, the drag on activity from higher energy prices should diminish over time.

All told, increases in energy prices over the past couple of years probably added about 1/2 percentage point to core inflation in 2005, and the lagged pass-through of past increases in energy prices appears likely to add roughly the same amount this year, provided that energy prices do not rise significantly further.

All told, the U.S. economic expansion appears to be solidly on track. Nevertheless, the outlook for real activity faces a number of significant risks, including the possibility that house prices and construction could retrench sharply and that energy prices could rise significantly further.

Although they are imprecise, simulations from the Federal Reserve Board staff's large-scale econometric model, which account for these effects, suggest that increases in spot and futures prices of energy from late 2003 to the present subtracted a 1/2 percentage point from real GDP growth in 2004 and more than 1 percentage point in 2005. The model suggests the subtraction this year will be about a 1/2 percentage point.

Saving last year was probably further depressed by the rise in households' energy bills. Over the next few years, saving relative to income is likely to rise somewhat from its recent low level.