The Federal Reserve is widely expected to step off the rate-hike escalator at Tuesday's policy meeting. But sustained high energy prices -- highlighted again by Monday's oil-price spike -- threaten to both keep upward pressure on inflation and slow economic growth. That could put a wrench in the Fed's hopes that a slowing economy will curtail inflation.

"The Fed is betting on a slowdown in the economy, but so far, high energy prices haven't had much of an impact" on growth, says Brian Wesbury, chief economist at First Trust Advisors. Typically, high energy prices cause a slowdown as companies strain to absorb the costs. This, in turn, drives down the price of these commodities, he says. "If the economy is slowing so much, why haven't we seen oil and industrial commodities come down farther?"

There was no coming down Monday, as the price of oil jumped as high has $77.30 per barrel intraday before retreating a bit to close up 2.97% at $76.98. The jump came after

BP

(BP) - Get Report

said it was shutting down its Prudhoe Bay oil field in Alaska, taking 8% of the country's oil production offline.

BP has a 26% stake in Prudhoe Bay and runs it for

ConocoPhillips

(COP) - Get Report

. BP shares fell 2.9%, while ConocoPhillips lost 1.3%.

Most other major integrated oil firms gained in concert with crude, including

Sunoco

(SUN) - Get Report

, which rose 4.9%, and

Marathon Oil

(MRO) - Get Report

, which rose 1.8%. The Amex Oil & Gas Index rose 0.7%.

Strength in energy stocks helped limit the downside effect of higher energy prices. The

Dow Jones Industrial Average

fell 0.2% to 11,219.38, while the

S&P 500

fell 0.3% to close at 1275.77. The

Nasdaq Composite

dropped 0.6% to close at 2072.50;

Hansen Natural

( HANS) was a big drag on the Comp, dropping 26% on heavy volume.

As was the case Monday, the stock market has largely been sanguine about oil prices for most of the year. Since early May, however, the most cyclical sectors have experienced more volatility as the market embraced the notion of an economic slowdown, and the world's central banks started to tighten.

The Dow Jones Transportation Index shows the market has embraced the slowdown story. The index hit an all-time closing high on May 9 at 4998.95, and surged again toward the high on July 3 amid the stock market's rebound rally from June 13 lows. But since investors embraced the notion of an economic slowdown and the Fed pause, the market leadership has rotated into the classically defensive sectors, leaving the Transports in their wake. The Dow Transports declined 1.42% Monday to close at 4316.43, or 13.7% below the May 9 high.

On Monday, 19 of the 20 Dow Transport components ended lower, with

Union Pacific

(UNP) - Get Report

,

JB Hunt Transportation Services

(JBHT) - Get Report

and

Burlington Northern Santa Fe

( BNI) among the big losers.

Not Your Father's Economy

The Fed (which removes food and energy from its favorite inflation measures) has indicated that as long as inflation is driven mostly by energy prices, as opposed to labor costs, the economy will withstand the pressure. Indeed, labor comprises 70% of the average

S&P 500

company's expenditures, while energy is only 5% to 10%, according to Tobias Levkovich, chief U.S. market strategist at Citigroup. But high energy prices can eventually lead to high labor costs. Back in the 1970s, for example, higher energy costs forced companies to increase wages so their workers could keep up. Still, much more of the workforce then was unionized and corporations didn't have today's trump card of outsourcing to tame U.S. laborers.

The U.S. consumer is technically not as taxed by energy prices at the moment as popular belief would have it. The consumer spends 5.8% of his income on energy, right around the average of the past 40 years, says Wesbury. The U.S. consumer spent 6.5% of annual income on energy in the 1960s, he notes, adding that incomes are rising faster than energy prices.

Moreover, consumer-confidence data show that people still believe elevated oil prices are a temporary phenomenon, meaning high energy prices may effect consumers with yet another 'lag effect.'

"It will be a gradual process

before people believe oil prices will stay up," says Marc Pado, chief investment strategist at Cantor Fitzgerald.

For now, consumers go driving through the summer believing the high price of energy is temporary, only to be shocked when winter comes around and their heating bill is higher and prices still haven't gone down. Their "Oh, this is the summer," or "Ohm this is the hurricane," or "Oh, this is the Alaska pipeline" excuses won't hold up by then, says Pado.

So the so-called tax on the consumer may come as a heaping serving of humble pie this winter. More especially to people facing higher adjustable-rate mortgage payments, decreasing wealth from the value of their homes and no increase in the minimum wage.

Meanwhile, the Fed may be set to pause, because the most damning inflation data could be rolling in. On Tuesday morning, the Labor Department reports second-quarter productivity, which could back the Fed into a corner of its own making. The Fed has stated that as long as productivity remains strong, any inflation pressures can be contained. This could be the quarter that turns that theory upside down.

Many economists expect productivity to slow to 0.9% on an annualized basis, meaning unit labor costs would jump 3.8% year over year. Last quarter, productivity climbed 3.7%, leaving plenty of cushion for a bit of inflation. As long as companies can make enough to absorb higher costs, they don't have to pass along those costs to the consumer in the form of higher prices.

But with the Fed's favorite inflation gauge, core personal consumption expenditures, running at a 2.4% annual rate, where does the 1.5% gap between productivity and higher costs get made up? Companies can accept lower profit margins or they can raise prices. They are likely to raise prices first, but if that doesn't work, "expect pink slips in December," says Pado.

Good luck, Dr. Bernanke.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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