The big declines in energy prices came toward the end of last year and the beginning of this year, and they're not going to wash out of the inflation data until late in this year. But the fact that energy prices have stabilized means that the pressure from that source is diminishing.

Another positive development for both the U.S. and the global economy is the sharp decline in energy prices. Lets start with the U.S. perspective. Despite the impressive recent gains in natural gas and crude oil production, the U.S. still is a net importer of energy. As a result, falling energy prices are beneficial for our economy. In economist parlance, falling energy prices are a positive terms of trade shock for the U.S. Over the near-term, this will lead to a significant rise in real income growth for households and should be a strong spur to consumer spending.

More broadly, the decline in energy prices also will be supportive to the global growth outlook in two other ways. First, by pulling down inflation in many countries it will spur more expansive monetary policy. We are already seeing this response in Europe and Japan. Second, the decline in energy prices is also likely to ease the global fiscal stance. Over the near-term, for oil exporting governments, falling revenue will not be fully offset by reduced expenditures. This will cause major oil exporters to run either smaller budget surpluses or bigger budget deficits.

Some fear that the strong rise in commodity and energy prices will lead to a more general sustained inflation. Yet, at the end of the day, such price shocks don’t create sustained inflation, monetary policy does.

Commodity prices have risen significantly in terms of all major currencies, suggesting that changes in the foreign exchange value of the dollar are unlikely to have been an important driver of the increases seen in recent months.

The rate of pass-through from commodity price increases to broad indexes of U.S. consumer prices has been quite low in recent decades, partly reflecting the relatively small weight of materials inputs in total production costs as well as the stability of longer-term inflation expectations. Currently, the cost pressures from higher commodity prices are also being offset by the stability in unit labor costs. Thus, the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation--an outlook consistent with the projections of both FOMC participants and most private forecasters.

Nevertheless, there are important mitigating factors that suggest that it would be unwise for the Federal Reserve to over-react to recent commodity price pressures. First, despite the general uptrend, some of the recent commodity price pressures are likely to be temporary. In particular, much of the most recent rise in food prices is due to a sharp drop in production caused by poor weather rather than a surge in consumption (Chart 26). More typical weather and higher prices should generate a rise in production that should push prices somewhat lower. This is certainly what is anticipated by market participants, as shown in Chart 27.

"I know we need to start by, if we were to do that, communicating to the market that we are not guaranteeing them the yield curve, that we are going to remove this language of ‘extended period,’" Hoenig, president of the Kansas City Fed, said in an interview with CNBC today. He said he didn’t know when the central bank may make such a move, while expressing a preference the Fed act this year.

The economy "has been improving," said Hoenig, who added that he believes the Fed should begin to consider "renormalizing" policy and that he favors "non-zero" interest rates.

Rising oil prices are not a "permanent" or "defining" factor for the economy right now, he said.

I don't think it's going to derail the recovery.  Luckily we have a lot of experience and a lot of track record and a lot of data to process on this, because we've been through this before, seeing oil-price spikes. So in the first instance, it's going to pass through to consumer prices. That'll take a little chunk out of real personal income. So far this seems quite manageable.

The real danger is inflationary psychology. In the last couple of decades, these haven't tended to pass through to core beyond just a little bit of a blip in a couple of months. And so I think as long as inflation expectations are managed pretty well, I think we're going to get through this without a big burst of inflation.

In response to a question about the impact of higher oil prices.

It seems to me that a change in the conduct of monetary policy following the experience of the 1970s has probably caused inflation expectations to become better anchored, explaining why recent oil shocks have inflicted relatively little damage on the economy. This hypothesis could at least partly explain why the huge run-up in energy prices through the middle of last year was not accompanied by rising wage demands. That in turn enabled the Fed to follow an easier monetary policy that gave greater weight to the output effect of rising oil prices than would have otherwise been possible.

Since mid-2008, oil prices have, of course, plummeted. But the extraordinary weakness in the economy means that the usual trade-offs associated with such supply shocks are absent right now. Any boost to spending from falling oil prices will be more than welcome in the current circumstances. And with inflation now below desirable levels, a decline in inflationary expectations that could push core inflation down over time would be most unwelcome. I argued earlier that the Fed’s inflation credibility helped over a number of years to keep inflationary expectations anchored in the face of rising oil prices and high headline inflation. My hope is that inflationary expectations will remain similarly well-anchored now, serving to stabilize core inflation. The FOMC’s recently released longer-run inflation projections should be useful in this regard, helping to reinforce inflation expectations of around 2 percent.

In industrialized economies, such as the United States, rising inflation has chiefly reflected the surge in energy prices, whereas in developing countries, for which food takes up more of household budgets, rising food costs have been a more important culprit. The reasons for the trajectory and persistence of increases in prices of food and energy this year, as global growth has moderated, are not entirely clear. The upward trend in prices of food and energy over the past several years, however, importantly reflects the pressures posed by rapidly growing demand in developing economies against relatively inelastic global supplies of commodities.

The results of such exercises imply that, over recent history, a sharp jump in oil prices appears to have had only modest effects on the future rate of inflation. This result likely reflects two factors.  First, commodities like oil represent only a small share of the overall costs of production, implying that the magnitude of the direct pass-through from changes in such prices to other prices should be modest, all else equal. Second, inflation expectations have been well anchored in recent years, contributing to a muted response of inflation to oil price shocks.  But the anchoring of expectations cannot be taken as given; indeed, the type of empirical exercises I have outlined reveal a larger effect of the price of oil on inflation prior to the last two decades, a period in which inflation expectations were not as well anchored as they are today.

More comprehensive statistical work by researchers at the Boston Reserve Bank concludes that the impact of relative price shocks from oil – and other related supply shocks – has had a very minor impact on the underlying rate of inflation.

Over the past year, the economy has been buffeted by a series of shocks including financial turmoil; an emergency acquisition of a major investment bank to avoid a sudden, disorderly failure [Footnote 2]; falling national housing prices; and oil prices that have exceeded $130 a barrel. Despite all these challenges, the U.S. unemployment rate is at 5 percent; the rise in prices of “core” consumer goods and services (Personal Consumption Expenditures) to a little above 2 percent, while unwelcome, has not been large compared with past episodes; and the economy has been growing, albeit at a much slower pace then we would prefer. These relatively benign outcomes to date are at least partly the result of recent monetary and fiscal policy actions taken to mitigate some of the problems facing the economy.

Determining appropriate policy necessarily involves more than figuring out the neutral real federal funds rate. This reality is especially obvious at present. Inflation has been elevated for some time and prices of commodities are surging. I find these trends particularly vexing at a time when global demand growth, most likely, has slowed.

In the near term, headline inflation is likely to continue to be boosted by the direct effects of the recent increases in the prices of energy and food. If, as futures markets suggest, those prices level off later this year, prospects seem reasonably good for headline inflation to move back in line over time with core inflation. And I expect core inflation to ease off slowly as commodity prices level out and as economic slack creates competitive conditions that inhibit increases in labor costs and prices