I want to note that our recent post-FOMC meeting statements came with a caveat that reads: “The Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.” To me, this language means that while we’re working to gradually remove the remaining policy accommodation in this time of elevated inflation risks, we also must watch carefully for unexpected developments in the economy, especially how individuals and businesses respond to the continuing rise in energy costs.

Even before the devastating hurricanes of August and September 2005, world oil markets had been subject to a degree of strain not experienced for a generation. Increased demand and lagging additions to productive capacity had eliminated a significant amount of the slack in world oil markets that had been essential in containing crude oil and product prices between 1985 and 2000. In such tight markets, the shutdown of oil platforms and refineries last month by Hurricanes Katrina and Rita was an accident waiting to happen.

Today, the average price of crude oil, despite its recent surge, is still in real terms below the price peak of February 1981. Moreover, since oil use, as I noted, is only two-thirds as important an input into world GDP as it was three decades ago, the effect of the current surge in oil prices, though noticeable, is likely to prove significantly less consequential to economic growth and inflation than the surge in the 1970s.

If history is any guide, oil will eventually be overtaken by less-costly alternatives well before conventional oil reserves run out...We will begin the transition to the next major sources of energy, perhaps before midcentury, as production from conventional oil reservoirs, according to central-tendency scenarios of the U.S. Department of Energy, is projected to peak. In fact, the development and application of new sources of energy, especially nonconventional sources of oil, is already in train. Nonetheless, the transition will take time. 

In contemplating monetary policy from this point forward, the brow begins to furrow. Most forecasters expect growth to slow from its previous pace—not so much because of the frightful destruction Hurricanes Katrina and Rita inflicted on the Gulf Coast but due to additional volatility in prices for natural gas, gasoline, certain chemicals and building supplies.

We must keep in mind that with expansions inevitably come increasing inflationary pressures.  In the near term, overall inflation will be affected by the substantial increase in energy prices.  To keep cyclical price pressures and any transitory spike in energy prices from permanently disrupting the price environment, the Fed will have to continue shifting monetary policy from its current somewhat accommodative stance to a more neutral one.

Despite their historical importance for aggregate inflation, energy prices, for example are controlled for in only one of the structural [inflation] models discussed at this conference.  And this importance is not necessarily a concern of the past: Prices for oil and natural gas have soared since 2003, directly boosting the energy component of the consumer price index as well as raising the production costs, and ultimately to at least some degree the prices, of non-energy goods and services.  As a policymaker, I can assure you that any model of inflation that did not take account of these effects, and how they might or might not affect ongoing rates of inflation, would have been or little practical use to the FOMC over the past few years.

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 is worth emphasizing that, after adjusting for inflation, the current price of oil is still well below the inflation-adjusted peak price reached during the oil shocks in the early 1980s. Moreover, the energy intensity of the U.S. economy is far lower than it was in those days.

Thus far, the U.S. economy has proven relatively resilient to the rising oil prices...Our economy has become more fuel-efficient, and as our output shifts from goods to services, it has become less energy-intensive. These trends render the economy better equipped to handle rising oil prices. Thus, while oil price increases have robbed the U.S. economy of some momentum, growth has remained quite healthy.

The aftermath of Hurricane Katrina has accentuated the concerns already in the market place and caused a further escalation in oil prices today. There is little doubt that the weather damage to our oil industry could be substantial and dislocations are likely in the short run.

In the near term, overall inflation will be affected by the substantial increase in energy prices...But this should be a transitory phenomenon.

A flattening out of the prices of crude oil and natural gas, were it to materialize, would...lessen upward pressures on inflation.  Overall inflation would probably drop back noticeably from the rates experienced in 2004 and early 2005, and core inflation could hold steady or edge lower.

Market participants now see little prospect of appreciable relief from elevated energy prices for years to come.  Global demand for energy apparently is expected to remain strong, and market participants are evidencing increased concerns about the potential for supply disruptions in various oil-producing regions.

One thing about Americans is that our cars are critical to our day-to-day existence.  And they do notice when gasoline prices go up.  And it probably does curtail other forms of spending...But what they don't do is drive fewer miles.