Worry about high oil prices or worry about aggressive interest rate hikes, but don't worry about both.

As long as energy prices remain a drag on the economy, the

Federal Reserve

will keep its promise of raising rates at a measured pace.

"I've heard arguments for the Fed to raise rates by ... 100 basis points by the end of year. Given the oil price situation, I'd argue against that," said John Silvia, an economist at Wachovia Securities.

Crude oil has jumped 26% this year and is now sitting close to its highest level on record, as demand remains very strong and supply is tight. Even though the Organization of Petroleum Exporting Countries is expected to raise production by as much as 1.5 million barrels a day, some analysts warn that energy prices could rise further as the summer driving season gets underway and unusually warm weather increases the demand for gas to run air conditioning.

Economists estimate that a penny per-gallon increase in the price of gasoline can translate into $1 billion in lost consumer spending. The national average for gas prices hit $2 a gallon this week, up more than 50 cents from the start of the year.

"You could argue that the economy has suffered through a $50 billion to $70 billion tax increase already," said Vincent Malanga, president of LaSalle Economics.

Malanga noted that soaring energy prices are hitting the economy just as fiscal stimulus and mortgage refinancing are fading. Although a pickup in the job market could help to support spending, he said consumers now have a higher debt burden after more than two years of easy credit.

A number of companies that are particularly sensitive to rising fuel costs are already bracing for the worst. In recent days, at least two airlines have said they will lose money in the second quarter because of high jet fuel costs. According to

The Wall Street Journal

, airlines could lose as much as $5 billion in 2004 if oil remains above $40 a barrel. Chemical firms, utilities and other transportation companies could also be in trouble.

Still, many investors continue to believe that the Fed will hike rates at every meeting this year, leaving the fed funds rate at 2% by the end of December. Short-term rates currently sit at a 45-year low of 1%.

Data on the job market and on inflation both suggest that ultra-low interest rates aren't needed any more. But with energy prices so high right now, some economists say the Fed won't be as aggressive in hiking rates as many people currently expect.

"It's a very tricky issue for the Fed," said Doug Porter, senior economist at BMO Nesbitt Burns. "It's not at all obvious how much monetary policy should respond to higher oil prices."

High energy prices can be both inflationary and deflationary, experts note, and the Fed must try to determine which force is more powerful. Porter believes concerns over inflation will probably dominate, and he expects rates to rise by 75 basis points this year.

But Malanga is calling for much more modest increases. "I think the inflationary aspect of oil is more of a concern to the Fed at a time when the economy is at the peak of a business cycle, or there is very little spare capacity and labor markets are tight," he said. "None of that is present at the moment."

Fed chief Alan Greenspan has "always paid a lot of attention to the deflationary aspect of high energy prices and I think there's a concern about that now; how that impacts behavior and spending patterns," Malanga added.

Wachovia's Silvia agrees with this view, saying expectations for sharp rate hikes this year are unrealistic.

"I think clearly, the Fed still is very concerned about the exogenous bolt from the blue shock that will lead to any kind of downward pressure on the overall economy," he said. "The bottom line is the Fed is concerned about higher oil prices reducing consumer disposable income or consumer confidence."

Since the economy is less dependent on oil than it once was, some economists say they aren't as concerned about the recent spike in prices. Energy input per unit of economic output is now less than half what it was 20 years ago.

Even if oil were to remain at $40 a barrel for the remainder of the year, David Gitlitz, chief economist at TrendMacrolytics, said it shouldn't inhibit economic growth or affect monetary policy. He believes large rate hikes are warranted.

"Barring sustained price acceleration at rates seen over the past six weeks or so ... this episode is unlikely to seriously threaten the positive forces now at work propelling growth forward," he said.

When adjusted for inflation, crude oil prices are currently a lot lower than they were in 1981. "To a considerable extent, it seems the trauma of the energy shocks of the 1970s and early 80s continue to shape perceptions of the risks arising from the oil price environment," he said. "The world, however, is a very different place."

Other experts aren't so sure. "We don't use as much as we used to, but we're not living in a brave new world where it doesn't matter," said Porter. "It certainly does matter."