By Jorge Alvarez, Alberto Musso, Jean-Marc Natal, and Sebastian Wende
The inflation surge over the past three years followed a unique disruption to the global economy.
Pandemic lockdowns initially tilted demand away from services and toward goods. But this came at a time when unprecedented fiscal and monetary stimulus boosted demand, and many firms were not able to ramp up production fast enough, resulting in mismatches between supply and demand and rising prices in some sectors.
For example, ports were stretched to or beyond their capacity, partly due to pandemic-related staffing shortages, so as demand for goods surged, this resulted in backorders. When economies reopened, demand for services came roaring back and Russia’s invasion of Ukraine sent commodity prices soaring, in turn pushing global inflation to its highest level since the 1970s.
Our chapter of the latest World Economic Outlook reflects on this episode, drawing lessons—both new and old—for monetary policy.
To understand the recent global inflation surge, we need to delve beyond traditional macroeconomic aggregates. Our modeling shows how inflation spikes in specific sectors became embedded in core inflation, a less volatile measure that excludes food and energy. Key to our analysis is the interaction between soaring demand and sector-specific bottlenecks and shocks. These caused large shifts in relative prices that resulted in an unusual dispersion of prices.
When supply bottlenecks became widespread and interacted with strong demand, the Phillips curve—the main gauge of the relationship between inflation and economic slack—steepened and shifted upwards. The steeper Phillips curve implied that relatively small changes in economic slack could have large effect on inflation. That came with bad news and good news.
The bad: inflation surged as many sectors hit capacity constraints. The good: it was possible to curb inflation at a lower cost in terms of lost economic output.
This last insight leads us to the new lesson: widespread supply bottlenecks can present central banks with a favourable tradeoff when confronting a demand surge. Because the Philips curve becomes steeper in such cases, policy tightening can be particularly effective at rapidly bringing down inflation with limited output costs.
However, when bottlenecks are confined to specific sectors with relatively flexible prices, such as commodities, we are reminded of an old lesson: the common practice of focusing monetary policy on core inflation measures remains appropriate. Excessive policy tightening in such cases can be counterproductive, leading to leading to costly economic contraction and resource misallocation.
Given these insights, central bank monetary policy frameworks should identify the conditions under which front-loaded tightening is appropriate. This requires enhanced models and better sectoral data to gauge underlying inflationary forces, improve forecasts, and guide the fine-tuning of policy responses. A first step in the right direction may involve collecting more frequent data for prices by sector and supply constraints to determine if key sectors are bumping against supply bottlenecks. Also, understanding structural factors such as how different sectors set prices and the links between them would provide additional valuable insights.
Several central banks plan to review their policy frameworks in the coming months. These reviews present an opportunity to incorporate well-defined escape clauses in their frameworks to tackle inflationary pressures when aggregate Phillips curves steepen. Forward guidance should internalise those escape clauses and allow for front-loading of tightening in such situations.
Such added flexibility should allow central banks to be better prepared in the future and help safeguard their hard-earned credibility.
The authors all work at the IMF. This article was originally posted here.
10 Comments
I thought this was covered in the central bankers handbook , " Reserve Banking for Dummies " ... Adrian Orr must've lost his copy ....
... in a nutshell , you only flood the economy with money as you did during a demand side crisis ... such as the great depression of the 1930's ... which was not the situation in NZ in 2020 ... we had a vibrant & strong economy until you & Robbo wrecked it ....
What we had was a supply side shock , during Covid19 ...and this required you to do diddly squat .. ...to sit under Tane Mahuta & read your book ...
in a nutshell , you only flood the economy with money as you did during a demand side crisis
I will play devil's advocate here. Lord Orr did not flood the economy with money. He's only responsible for base money: currency in circulation, bank reserves with the central bank, and the govt's account with the central bank. He's only 'indirectly' responsible for broad money. There are two main of broad money supply over time: either banks make more private loans and thus create new deposits (which increases the money multiple, the ratio of broad money to base money), or the government runs large fiscal deficits while the central bank creates new bank reserves to buy large portions of the bond issuance associated with those deficits (which increases both broad money and base money).
So if anything, Lord Orr is a 'chief enabler'.
The Funding for Lending program was friggin' outrageous in my opinion. Bureaucrats picking winners; in this case, the Ponzi. While I understand that "everyone was scared", the problem is that I don't believe they can effectively quantify the trade-offs and outcomes. Orr and the pointy heads would say the alternative of not doing anything would have been far worse, but the problem is that they don't show us their numbers (the fact that most people couldn't understand those workings is beside the point).
Great post.
I think you're bang on the money when you say, "everyone was scared". At that time, the RBNZ was faced with a choice. Either hunker down and respond to what could happen. Or top up the punch bowl (and keep it full to overflowing) in case the worst scenario they could think of transpired. Obviously, they chose the latter. Most central banks, especially those who saw mild inflation post-event (mainly due to that fool Pootin), went for the former. One for the textbooks. (And the textbooks will not be kind to the RBNZ - but, on the plus side, it will be a historical reference point on "what not to do".)
A central bank being placed in charge of inflation is fraught with problems. They're not supply orientated in their approach (tools) or knowledge base.
Although it also very hard to model for the cost implications of such widespread disruption to production and distribution. We managed to make things cheap using a very efficient, but also fragile global system. With almost no warning that fell apart. Shit got scarce, and expensive, at the same time central banks poured some kero on the fire. The choices to overcome this sort of issue are also not cheap. You're into having larger stockpiles on rotation, or re-shoring some of your production.
My view is the real question we should be asking is how much will we sacrifice to be part of this global system which carries a range of benefits, costs, and exposure? Or how much will we sacrifice to make some heavy alterations to our approach to it?
Thanks for the head nod. But I think "everyone was scared" amplifies the point about the Ponzi being the be-all-and-end-all. It's a tacit admission that it's too big to fail so the hoi polloi have to be protected at any cost. So while that seems 'responsible' in terms of leadership, it seems like they've ignored everything else. That just makes matters worse going forward. Given what's going on everywhere (particularly in the Anglosphere) with public debt, it's important to be alert. For your own survival.
Good post. I would hope next time that RBNZ ask the Govt what they are going to do before going into hero mode. If Govt say they are going to deficit spend 7% to 8% of GDP to save businesses and jobs, then RBNZ should do a brief assessment of the likely current account deficit, and then make a call on how much monetary stimulus might be required. If they had done this in March 2020, the answer they would have got to would have been 'Zero. Don't do anything at all. Stand down'. Here's the fiscal, monetary and current account balances stacked up for reference. Here's a more detailed look.
Completely agree Jfoe and like the reference to 'hero mode.' While not being an expert, I am pretty sure that the coordination between RBNZ and Treasury is not as tight as say that of the BoJ and Ministry of Finance. But that's partly because they like us to believe in the West that the central banks are independent. IMO, they are, but not in a good way.
"I would hope next time that RBNZ ask the Govt what they are going to do before going into hero mode."
My recollection of events is that government got out their big cheque book first.
Ergo, the RBNZ should have done the same maths we did, and as Treasury should have done as well before immediately sending the RBNZ a "please explain why" email.
"Given these insights, central bank monetary policy frameworks should identify the conditions under which front-loaded tightening is appropriate. "
Good advice.
Of course, our RBNZ had quite different ideas and did the opposite.
And here we are ... With our RBNZ having created conditions that will surpass the GFC fallout.
"Too slow to act. And then holding too high, for too long."
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