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."

A lot of our contacts within the district since the beginning of the year, since the spring, have been reporting that they're increasingly able to pass along cost increases, energy cost increases in the form of high prices — something we weren't seeing a year ago.

The Fed, in the short run, tolerates the pressure rising energy prices exert on headline price measures, Mr. Bernanke said. "Our objective is to make sure it doesn't pass through into other wages and prices, in other words, that there are not second-round effects," he said.

"In the long run, what we would like to control is headline inflation," Mr. Bernanke said, "After all, that's what is determining the value of money, and it's what people need for their planning," along with being the force that "affects real wages and real incomes," he said.

"It is very difficult to eliminate the inflationary impact of the immediate effects of an increase in energy prices," he said. "Doing so would require forcing down wages and other prices quite dramatically to keep the overall price level from rising."

From Q&A session reported by the Wall Street Journal

I just don't think that growth by itself is going to take inflation down. I'm not sure how many people really view that as going to be the key driving force of inflation going forward. What I think is more likely is the fact that the increases in core inflation we've seen thus far have been in response to oil price increases. And if oil prices - energy prices trace out the trajectory implied by futures markets, which is to say fairly flat from here on out, then that pressure from oil price increases is - on core inflation is likely to subside. And I think that's where, you know, where the hope is for bringing inflation down without further rate increases and we said that again, obviously in the camp of thinking that we needed to raise rates to make sure that inflation comes down.

And so this increase in energy prices and commodity prices certainly has been a significant contributor [to inflation]. And I think that we wouldn't really be talking about this now if energy prices were still $30 or $40 a barrel.

To the extent that the Fed's credibility is strong and people think that inflation will be low in the long term, when energy price increases hit, it causes a temporary burst of inflation. But if nobody expects it to continue, then it will just moderate away and we don't get into this pattern of having to raise rates a lot and getting into an inflationary situation.

Although the rate of pass-through of higher energy and other commodity prices to core consumer price inflation appears to have remained relatively low in the current episode--reflecting the inflation-fighting credibility built by the Fed in recent decades the cumulative increases in energy and commodity prices have been large enough that they could account for some of the recent pickup in core inflation.

As yet, these [inflation] expectations measures have remained within the ranges in which they have fluctuated in recent years and inflation compensation implied by yields on government debt has fallen back somewhat in the past month. Nevertheless, these developments bear watching.

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.

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.

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.

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.