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. 

As in 2005, consumer spending is expected to be a primary contributor to growth in 2006.  In recent months, consumer confidence measures have sharply rebounded from the hurricane-related decline last fall.  More importantly, consumer expectations of the future are positive.  One possible drag on consumption lies in the persistence of high energy prices, especially for natural gas.  High utility prices for heating are expected to constrain spending somewhat during the winter months...Overall, I expect to see consumption growth of around 3 percent for 2006.

In the international sector, continued strong growth in the rest of the world will slow the growth of the trade deficit.  An expanding world economy is expected by many economists to generate increasing demand for U.S. exports.  Such growth, however, is also likely to further increase global demand for natural resources.  This implies that prices for commodities such as oil may remain at elevated levels for an extended period of time.

Immediately following Hurricane Katrina, as the magnitude of the effects on Gulf Coast energy production became clear, many observers came to fear that the resulting sharp increase in energy prices might lead to a broader increase in inflation, and perhaps even recessionary forces. These observers appeared to be reasoning by analogy to the 1970s, but I believe that analogy is mistaken. Inflation expectations were unanchored in the 1970s, the credibility of the Federal Reserve was low, and people expected the Fed to allow energy price shocks to feed through to overall inflation. The Fed often accommodated that expectation by preventing short-term real interest rates from rising. In fact, at times we kept nominal rates from rising as fast as inflation and thus provided further monetary stimulus. The Fed was then forced to raise rates dramatically to bring inflation back down, and in the process induced an economic contraction, exacerbating the real effects of the oil price shocks. Thus, the proper lesson from the 1970s is not that energy price shocks induce major recessions or cause widespread inflation; it is that monetary policy that reacts to energy price shocks by accommodating the rise in inflation can induce major recessions. Monetary policy should respond to energy shocks by remaining focused on price stability. That way, the economy can respond to energy price shocks the way it should — the relative price of energy increases, but core inflation remains anchored.

Thus far, market participants appear to believe that core inflation will remain contained. Survey measures of expected inflation rose sharply in September when retail gasoline prices reached their peak, but have come back down since. Measures of expected inflation derived from market prices of inflation-protected U.S. Treasury securities drifted up a bit this fall, but they too have returned to mid-summer levels. To maintain credibility for price stability, it is essential that monetary policy should respond vigorously to any visible erosion in inflation expectations.

Of course, we normally would expect the year-and-a-half-old energy price surge to push down spending...Recent data suggest, however, that consumer spending has held up well so far.  For example, although personal consumption expenditures were up only modestly in October, they were held down by a big drop in auto sales that probably reflected reduced sales incentives; outside of autos, personal consumption expenditures were robust, despite the surge in energy prices and plummeting confidence.  Indicators of business spending and output also have held up well.  It is possible that higher energy prices have had a negative impact on consumer spending, but the drag from this factor has been offset by other stimuli to spending such as rising home prices and growth in disposable income.

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 large amount we spend on imported energy... [t]he price increases act like higher taxes, negatively affecting economic growth. So why haven't we seen a slowdown in U.S. economic growth over the past couple of years? First, solid productivity growth and accommodative monetary policy have offset some of the negative effect of rising oil prices. Second, the increase in crude prices, after adjusting for inflation, is smaller than during the 1970s, and the level remains well below the peak reached in 1980 of $86 per barrel in 2005 dollars. And third, the U.S. economy is less dependent on oil today.

During the 1970s, inflation expectations were very poorly anchored. There was very little confidence that the Fed would keep inflation low and stable. When oil prices rose, those price increases fed through quickly into other prices and began to raise the general rate of inflation quite quickly.

The Fed responded somewhat in a panicked way by raising interest rates enormously, which then contributed to the deep recessions of 1975 and 1981-'82.

In a more recent episode, we've had extensive increases in energy prices, but outside of the energy sector, if you look at core inflation, core inflation remains very well controlled. And as a result, the Fed Reserve has been able to raise interest rates from its low accommodative level, but to only 4 percent at this point. And the economy is growing strongly.

So I think this is an enormously good illustration of why keeping inflation low, stable and keeping expectations well-anchored is of tremendous benefit, not just on the inflation side, but also on the employment and growth side.

From the Q&A session

Natural gas prices have been rising for some time. And it's proved a very heavy burden to chemical manufacturers, alumina, other manufacturers in the United States. That's a real problem. I don't want to understate that problem at all. But...monetary policy...can only try to avoid having those price increases spread into general inflation. Monetary policy can't create more energy. It can't really solve the energy problem.

Although energy prices are still high, they have been falling recently, and futures markets expect energy prices to continue falling modestly next year.

The disruptions to energy production have noticeably affected economic activity. We estimate that the storms held down the increase in industrial production 0.4 percentage point in August and an additional 1.7 percentage point in September. Except for the hurricane effects, readings on the economy indicate a continued solid expansion of aggregate demand and production. If allowance is taken for the effects of Katrina and Rita and for the now-settled machinist strike at Boeing, industrial production rose at an annual rate of 5-1/4 percent in the third quarter. That's up from an annual pace of 1-1/4 percent in the second quarter.

I am reluctant to bet against the strength of the American consumer. But with gasoline at or near $3 a gallon recently and other energy costs such as natural gas almost doubling in the past year, consumers may face tough choices in how they allocate their spending. In the final months of 2005, consumer spending could slow a bit if caution causes households to reduce borrowing or increase the rate of savings.

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.