As for inflation, the rise in energy costs has had a significant impact on overall or "headline" inflation and has likely also affected core inflation (which excludes the direct effect of energy price increases), although thus far the impact on core inflation appears to have been relatively modest. In the longer run, these inflation effects should fade even if energy prices remain elevated, so long as monetary policy keeps inflation expectations well-anchored by responding appropriately to future price and output developments.

Six months ago...the energy price surge had led some observers to expect to see those prices pass through to a broad range of prices of goods and services, much like what happened in the 1970s. But that hasn’t happened. Core inflation has been low and relatively steady in the last several years. Our preferred inflation measure, the price index for core personal consumption expenditures, has risen 1.8 percent over the last 12 months. Despite rising energy prices, core inflation actually fell slightly last year, since the core price index had risen 2.2 percent in 2004. Similarly, we are not seeing any sign of rising inflation in the most recent data.

All told, increases in energy prices over the past couple of years probably added about 1/2 percentage point to core inflation in 2005, and the lagged pass-through of past increases in energy prices appears likely to add roughly the same amount this year, provided that energy prices do not rise significantly further.

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.

With little confidence that the Fed would keep inflation low and stable, the public at that time reacted to the oil price increases by anticipating that inflation would rise still further. A destabilizing wage-price spiral ensued as firms and workers competed to "keep up" with inflation...

By contrast, the oil price increases of recent years appear to have had only a limited effect on core inflation (that is, inflation in the prices of goods other than energy and food), nor do they appear to have generated significant macroeconomic volatility. Several factors account for the better performance of the economy in the recent episode, including improvements in energy efficiency and in the overall flexibility and resiliency of the economy. But, the crucial difference from the 1970s, in my view, is that today inflation expectations are low and stable (as shown, for example, by many surveys and a variety of financial indicators). Oil price increases in the past few years, unlike in the 1970s, have not fed through to any great extent into longer-term inflation expectations and core inflation, as the public has shown confidence that any increases in inflation will be temporary and that, in the long run, inflation will remain low. As a result, the Fed has not had to raise interest rates sharply as it did in the 1970s but instead has been able to pursue a policy that is more gradual and predictable.

Today, we see oil prices going up, but we see very little response in wages and prices. We see overall inflation relatively stable. We don't have to have the same aggressive monetary policy response we had in the '70s. And that's a direct benefit of the improvement in inflation expectations that we've gotten in the last 30, 35 years.

Turning to prices, core inflation has stayed relatively low in recent months despite the run-up in energy costs...Although energy prices have receded from the highs last fall, crude oil costs are still well above year-earlier levels. As a result, gasoline prices remain elevated despite a decline of about 70 cents per gallon from the peak recorded in the aftermath of the hurricanes. The prices for home heating oil and natural gas will add to consumers' budget pressures this winter; although spot prices have moved lower in recent weeks, they are still well above year earlier levels. Higher energy prices have also affected businesses, particularly in those industries with energy-intensive production processes and those that purchase a large share of energy-intensive products, such as industrial chemicals and plastics. There is only limited evidence, most of it anecdotal, of pass-through to consumer prices from the run-up in energy prices. However, we are seeing the effects in the price data for certain energy-intensive categories, such as transportation. 

Inflation expecations have become "well anchored" to price stability--most likely because people are confident that the Fed will act to limit any potential rise in inflation.  This may account for research results suggesting that, during this period, energy price increases have generally not been passed through to core inflation.

Given the persistence of high energy prices that the global economy has confronted of late, policymakers cannot be complacent. Central bankers must reinforce their credibility and validate the confidence of market participants by actively leaning against inflationary pressures long before inflation itself builds. Again, the FOMC has done just that through its commitment to adjust policy as required to keep inflation at bay.

Rising energy costs probably won’t lead to a persistent and broad-based rise in inflation if—as is the case, in my view—the marketplace does not perceive the general price level to be increasing.

The hurricanes have...adversely affected the outlook for inflation. The damage to production and refining facilities has significantly boosted the prices of natural gas and gasoline. Consumer energy prices are projected to rise substantially in the second half of this year, and some spillover into the prices of non-energy goods and services looks likely as well.

A large, long-lasting increase in the relative price of energy will affect inflation for a time. Although short-run swings in firms' energy costs might be absorbed in their profit margins, a persistent increase is likely to be fully passed on to the consumer...However, if households and businesses believe that the central bank is committed to preserving price stability, the likelihood that inflation expectations will become unanchored decreases. Thus, the preservation of the credibility of the central bank's resolve to contain inflation is one of the key elements in the adjustment to a higher relative price of energy.

We simulated FRB/US using the path for crude oil prices that futures market participants in December 2003 expected to prevail over the following three years. We also simulated the model with the revisions to futures prices that occurred subsequently over 2004 and through mid-September of this year. Based on a comparison of these simulations, we estimate that real GDP growth was held down 1/2 percentage point in 2004 and 1 percentage point this year relative to what it otherwise would have been. The drag on real GDP growth next year would be comparable to that in 2004. As higher energy prices are passed through to the prices of other goods and services, prices for core personal consumption expenditures (core PCE) are estimated by the model to have been boosted 1/4 percentage point last year and more than 1/2 percentage point in 2005. Given the lags in the inflation process, core PCE inflation rises a bit further relative to baseline next year.

Thus far at least, the growth effects of energy price increases appear relatively modest. The economy is much more energy-efficient today than it was in the 1970s, when energy shocks contributed to sharp slowdowns, and real energy prices remain below the peaks attained in the 1970s and early 1980s. Well-controlled inflation and inflation expectations have also moderated the effects of energy price increases, since those increases no longer set off an inflation spiral and the associated increases in interest rates, as they did three decades ago.

It seems likely that, even with inflation expectations well contained—which they have been according to most indicators—higher oil prices may be partly passed through to core inflation at least for a time.