Gas at $5/gallon?

I've been conducting a (very) informal poll for the past couple of weeks. I've been asking people this question: If you could enter into an agreement that would lock in your price of gasoline for the next year at $5 per gallon, would you do it? The responses have been mostly negative, but the question has sparked some very interesting discussions.

The answer to this question interests me because it reveals the degree to which the recent acceleration in gasoline prices have affected a person's expectations for further price gains. The mostly negative response to my question tells me that inflation expectations have not yet become deeply entrenched (at least among my clients and friends) and this is very important. Inflation does its greatest damage when expectations for high inflation get baked into general perceptions about the future. When that happens, it becomes very difficult and painful to wring inflation expectations out of the economy.

As a case in point, consider the U.S. experience in the 70's after the 1974 oil embargo. At that time, year-over-year core inflation (or, inflation excluding food and energy) averaged 7.9 percent. Beginning in 1979 and continuing through the early 80's, it took the Fed's "tough love" approach--including 18 percent interest rates and a very nasty recession--to finally squelch those expectations. The impact of that "tough love" lingered for many years. In 1988, when I bought my first house, my mortgage rate was 9.375% and I thought it was a great interest rate.

With gasoline now at close to $4.50 per gallon, a rise above $5 per gallon is very possible. Some pundits claim we will see it breach that level and go much higher. Whether they do or not is anybody's guess. But the thing I will be watching is how those price gains effect general inflation expectations.