The Committee's aggressive monetary easing was not without risks.  During the early phase of rate reductions, some observers expressed concern that these policy actions would stoke inflation.  These concerns intensified as inflation reached high levels in mid-2008, mostly reflecting a surge in the prices of oil and other commodities.  The Committee takes its responsibility to ensure price stability extremely seriously, and throughout this period it remained closely attuned to developments in inflation and inflation expectations.  However, the Committee also maintained the view that the rapid rise in commodity prices in 2008 primarily reflected sharply increased demand for raw materials in emerging market economies, in combination with constraints on the supply of these materials, rather than general inflationary pressures. 

Competitive trading markets are impressively effective mechanisms for weighing and amalgamating widely divergent views, and so one shouldn't ignore the information embodied in market prices, and I don't. The implied forecast misses have been predominantly on the high side in recent years, however. The risk for inflation dynamics is that elevated rates of increase in overall price level become embedded in expectations.

Policymakers and other analysts have often relied on quotes from commodity futures markets to derive forecasts of the prices of key commodities.  However, as you know, futures markets quotes have underpredicted commodity price increases in recent years, leading to corresponding underpredictions of overall inflation.  The poor recent record of commodity futures markets in forecasting the course of prices raises the question of whether policymakers should continue to use this source of information and, if so, how.

Despite this recent record, I do not think it is reasonable, when forecasting commodity prices, to ignore the substantial amounts of information about supply and demand conditions that are aggregated by futures markets...

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.

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."

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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

I do not expect the recent elevated inflation rates to persist.  In my view, the adverse dynamics of the financial markets and the economy have presented the greater threat to economic welfare in the United States.  But the recent information on prices underlines the need to continue to monitor the inflation situation very carefully.

...

I expect the run-up in headline inflation to be reversed and core inflation to edge lower over the next few years.  This projection assumes that energy and other commodity prices will level out, as suggested by the futures markets.  Moreover, greater slack in the economy should reduce pressure on prices and wages.  Despite high resource utilization over the past couple of years and periods of elevated headline inflation, labor cost increases have remained quite moderate, and inflation expectations remain reasonably well anchored.

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.

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

     Well, we approach {energy price forecasting} at the Federal Reserve on essentially two levels.

     First, we try to do a fundamental supply-and-demand analysis, try to look at how we expect demand to grow both not only in the United States, of course, but in emerging markets and around the world and where we see supply emerging in OPEC and outside of OPEC, and try to make some sense of where that market is going.

     But another very important piece of information is futures markets. Investors in -- dealing in NYMEX and other futures markets put their money, essentially making bets where they think the price of oil is going to be at various horizons going out to six or more years.

     Those futures markets have been wrong in the past. They have underestimated the increase in oil prices that we've seen, which is one reason why we're very cautious about it. But over long periods of time they're probably about the best source of information we have about where the markets see energy prices going.

     And so the markets -- those energy markets currently see oil prices remaining high, but leveling off over the next couple of years, to the point where, if that actually happens, overall headline inflation would be about the same as core inflation.

From the Q&A session

However, futures markets expect energy prices to stabilize around current levels. If they do, then the restraint we've felt this year should evaporate over 2007, and that could actually contribute to a pickup in growth next year.  But that's a very big "if."

If you look even today at the futures markets, the futures markets predict energy prices will be relatively flat over the next couple of years. If you take that forecast as correct, then today's core inflation rate is actually a reasonable forecast of tomorrow's total inflation rate if energy prices do, in fact, flatten out as the markets seem to expect.

Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters; such an outcome would, over time, reduce one source of upward pressure on inflation.  However, expectations of a leveling out of oil prices have been consistently disappointed in recent years, and as the experience of the past week suggests, possible decreases in these and other commodity prices remain a risk to the inflation outlook.

But beginning around 2003, futures prices began moving up roughly in line with the rise in spot prices. Thus, unlike in earlier episodes, the significantly higher relative price of energy that we are now experiencing is expected to be relatively long lasting and thus will likely prompt more-significant adjustments by households and businesses 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.

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.