There still is growth in the world economy, even if we slow down. It's difficult for me to see a supply response that will feed into that demand to relieve all the price pressures we see on oil.

As reported by Reuters

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.

That's not noise.That's a signal.

On oil prices reaching $120 a barrel and other energy demand trends.

Will the U.S. slowing down really damp the price of oil, or the price of food, rice, or flour, cornmeal, the price of steel? … It’s not clear to me that a mild slowdown will put a dent in price pressures domestically. Obviously if you have a tail risk of a very severe global slowdown, then yes, I can see that. I don’t see that in the cards at least from my limited perspective. If you think in closed-economy terms, that’s more likely to obtain. If you think in global terms, it is less likely to obtain unless the whole world slows down.

Even as the outlook for real activity has weakened, there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well. Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

Since August, however, the inflation picture has deteriorated. In September and October, the overall PCE price index rose at a 3.3 percent annual rate, and the core index rose at a 2.6 percent rate. Judging by the closely related consumer price index, the numbers for November will be even worse. Now these numbers do display transitory swings, so I wouldn't extrapolate them forward indefinitely. Still, I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.

I am also troubled by the lengthy divergence we've seen between overall and core inflation. Some of you may recall that core inflation was devised in the 1970s to filter out some of the more volatile consumer prices to get a better read on inflation trends. For several decades, core inflation seemed to work well due to the fact that food and energy prices had no clear trend relative to the overall price level. In the last few years, though, overall inflation has been persistently above core inflation, and few observers expect oil prices to go back below $20 per barrel. Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation. Going forward, markets expect oil prices to back off slightly from their current level, and I hope they are right. If energy prices fail to decline, monetary policy decisions will be that much more difficult in 2008.

[H]igher oil prices caused by productivity gains have a much different effect on the economy than oil supply shocks. A productivity shock originating in the U.S. will boost our economic output, and the expansion will pull up the price of oil. If monetary policy holds the growth of nominal GDP constant, this will result in a reduction of inflationary pressures. If China or India or some other country is expanding rapidly and it is the country's oil consumption that is increasing, driving up prices, that surge in productivity can yield spillovers for the U.S. in the form of lower import prices and technological gains. As long as this continues, we can expect to see an expansion of output and lower overall prices, even as the world price of oil rises. A vicious cycle is, in a sense, almost transformed into a virtuous cycle.

With each uptick in energy prices, I ask whether it is supply or demand that is making prices rise. Supply disruptions are cause for concern, but growth in demand is not as worrisome. Most likely, energy prices will continue to be volatile; it is the nature of the beast. The same goes for food prices.

The reality of rising oil and commodity prices is evident, and my Federal Reserve colleagues and I have been clear about our belief that the impact of these influences will dissipate over time. But until our beliefs are validated by the data, there is a risk that the public's trust could erode and inflation expectations could move higher.

[T]he reduced sensitivity of core inflation to oil and natural gas prices likely also reflects both the increased energy efficiency of the economy and the fact that shocks to the prices of these goods since the mid-1980s have, at least until the latest episode, been viewed as mostly temporary. In contrast, the rise in oil prices during the 1970s was probably seen at the time as largely reflecting a permanent shift in global demand/supply balances.

The economy has performed well despite a near tripling of crude oil prices since December 2001. In years past, an energy price shock of this magnitude was typically associated with a substantial increase in inflation and a sharp recession.

Two things are different about energy price increases this time. One is that the increases were primarily a consequence of a booming world economy, which raised energy demand rather than a supply shock. Second, monetary policies here and in most other countries have done a fine job of anchoring inflation expectations.

Certainly, the recent data on consumer prices have been encouragingly consistent with the downward tilt to inflation that the FOMC has been expecting. However, we need to be cautious about extrapolating trends from a couple of months of data. The data themselves are noisy--subject to month-to-month variations that are unrelated to more-persistent developments. And we need to recognize that some of the very recent disinflation may represent one-time influences. Energy costs have moved down markedly in recent months, and those declines have fed through to prices for a number of intermediate goods and probably for some final goods as well. But futures markets anticipate that prices of crude oil will increase gradually, which suggests that, once the adjustment to the current level plays out, energy prices will no longer work to restrain total and core inflation. And if a portion of the weakness in goods prices reflects efforts by producers to forestall or correct inventory imbalances, that restraint on pricing will dissipate as firms' corrective actions take effect.

The decline in oil prices we saw last year [2006] was certainly welcome, and helped to bring inflation down from its mid-year peak. But absent further declines, lower energy costs won't bring about much of an additional decrease in inflation this year.

[I]t is likely that {passthrough} has played at least some role in recent core inflation movements. Now that energy prices have fallen a fair bit from recent highs and are expected by futures markets to remain at those lower levels, this upward pressure on core inflation is likely to dissipate and could even turn into modest downward pressure at some point.

But let me note that we shouldn't exaggerate the importance of this point. Recent analysis suggests that the extent of passthrough for any given rise in energy prices has been lower in the past twenty-five years than it was back in the 1970s.1 For a specific example, consider airfares, which have increased markedly over the past year. Considering that jet fuel accounts for one-eighth to one-fourth of airlines' operating costs, it would make sense to think they have passed through higher fuel prices into airfare increases. However, some simple calculations show that the cost increases from rising jet fuel are likely insufficient to explain more than a portion of the airfare increases, and that higher load factors are likely to be part of the explanation.

The pass-through turns out to be harder to find either econometrically or in the price data themselves than any savvy consumer might think… [T]he small acceleration in many other {non-energy-intensive} nonshelter portions of the index, while consistent with a small pass-through of energy costs, could also be attributable to non-energy factors.

In the final analysis, I think we probably saw some pass-through of higher energy costs into core inflation once price and wage setters came to believe that the rise in energy prices would not soon be reversed. But the magnitude of the effect has been small--perhaps on the order of a cumulative 1/2 percentage point or less since the end of 2003. If crude oil prices hold at close to current levels over the next few years, the resulting absence or even partial reversal of these energy cost shocks should, all else equal, put some modest downward pressure on core inflation.

[R]ecent research suggests that the extent of passthrough for any given rise in energy prices has been lower in the past twenty-five years than it was back in the 1970s. However, it seems likely that energy passthrough probably has played at least some role in recent core inflation movements. In this case, if energy prices level out, as expected by futures markets, this upward pressure on core inflation is likely to dissipate at some point, and this would help on the inflation front.