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.

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

Looking ahead, the path of far-dated futures prices for oil indicates that markets are not expecting prices to rise significantly further. However, given strong global demand for energy resources and the ever-present risk of supply disruptions, additional increases in energy prices cannot be ruled out. Such increases would boost the overall inflation rate and might put additional upward pressure on production costs and inflation expectations, which in turn, could create forces that would tend to push core inflation up. If that were to occur, the Fed would need to be particularly vigilant to ensure that inflation remained under control.

Over the last several decades, most fluctuations in oil prices have proven to be "transitory" and, not surprisingly, the view that oil price jumps will be temporary is typically reflected in futures prices. During the run-up of spot oil prices over the past year and a half, in contrast, far-dated oil futures prices also have increased sharply, suggesting that high oil prices may be here to stay. This is a highly unusual development.

The direct contribution of rising commodity, energy, and other import prices to consumer inflation is likely to lessen considerably, however. Commodity price increases have slowed; the dollar has flattened out in recent months, which should damp import price increases; and, if they conform to the expectations implicit in futures markets, oil prices should level off and then drop back a bit.

Although traders expect the price of oil to decline somewhat from recent highs, they also believe that a significant part of the recent increase in prices will be long lived.

I should acknowledge that oil futures prices have a less-than-stellar record in forecasting oil price developments, but they are probably the best guide that we have. Chinn, LeBlanc, and Coibion (2001) find that futures quotes are unbiased predictors of future spot prices, though not very accurate ones.  

[Chinn, Menzie, Michael LeBlanc, and Olivier Coibion (2001). "The Predictive Characteristics of Energy Futures: Recent Evidence for Crude Oil, Natural Gas, Gasoline, and Heating Oil,"  (99KB PDF) unpublished paper, University of California, Santa Cruz.]