Dancing between raindrops: tackling an Iran-related supply shock

“Was the inflation shock last year temporary or permanent? … 
[The answer] is always a function of the central bank response: it is not exogenous and is controlled by the central bank.”

Royal Economic Society Public Lecture, June 2022, at the University of Glasgow

Here we go again. Another supply shock faces bemused central bankers whose heads are likely to be in a spin, having suffered some opprobrium from the huge inflation shock in 2022 and temporary loss of price stability. And just when we thought we were heading back to price stability, along comes another negative supply shock of indeterminate size and duration. What lessons have we learnt and how can we apply them this time? 

At face value, there are many similarities to 2022. Energy prices are going up rapidly and will bring about a distributional shock globally, with (net) energy consumers losing out in terms of income relative to producers. Global inflation will likely creep up and income growth will fall. This impetus has already acted to raise bond yields, with investors predicting higher policy rates than previously expected, and lower equity prices as profits are expected to be hit as a result of increased costs of production and transportation. This much is standard. 

But we need to add to the mix this time the pivotal nature of the Middle East, not only in terms of energy production but also for the flow of gas and oil from east to west. This means the scope for an impact on the real economy may be substantively higher than following the Russian invasion of Ukraine in February 2022. The implication is that a loss of confidence and increasing levels of geopolitical uncertainty may interact with the initial shock to amplify the inflation and growth effects to a much greater extent than in 2022.

Of course, monetary policy cannot replace the loss of permanent income, but it can help the energy-importing economy adjust to the lower level of national income and ensure there is no de-anchoring of inflation expectations. Supporting such an adjustment will imply tighter monetary policy than that expected prior to the negative supply shock. 

It seems attractive to me to develop a dominant narrative that emphasises central bank anti-inflation vigilance

US president Donald Trump hinted on March 9 that he was looking to end the war with Iran soon. But let us suppose that under some worst-case scenario, even though we are not facing a 2022 food price shock as well (so far), that we are about to face an extended period of higher energy prices and various forms of supply disruptions. How should a central bank, whose primary aim is price stability, respond? 

Let me first state that the answer last time was actually easier. Policy rates had been abnormally low for a generation and in serious need of normalisation in the presence of large positive output gaps. Following Covid-19, monetary and fiscal policy had created a huge pool of global liquidity that needed to be drained. And central banks had an opportunity – which sadly not all took – to burnish their anti-inflation credentials by stating with clear communication strategies that they would increase real rates and act in a manner that would limit second-round effects, minimising the risk that inflation would become embedded in wage and price settlements into the future. Once central banks accepted their responsibilities, we eventually moved in the right direction.

Prior to February 28 and the commencement of hostilities in the Middle East, the main question facing central banks was the rather mundane one of where policy rates should move from the current level – towards neutral or below it. There was some disagreement on the terminal point, as there should be in a stochastic world. Either way, the recent debates on the fine-tuning of policy rates always seemed to me to be of second order as we were in the neighbourhood of the right level.

This time the negative supply shock has struck economies that are broadly at full capacity. We know that a persistent negative supply shock to energy prices will reduce potential output and, should demand remain constant, implies a clear need for policy rates to be higher than otherwise. In this case the task may be to persuade market participants forming expectations about the stance of policy that it will be not be eased as much as they previously thought. In effect, no change in rates can imply a tightening if the yield curve flattens rather than being inverted. But there are possible complications. If demand is strongly affected – through investment plans, a reduction in real consumer spending power and a contraction in world trade – then policy may face some pressure to support demand and ensure a balance in the paths of demand and supply. There may even be a need to ease policy.  

Central banks, as cautious beings, may at first pass be tempted to treat the energy price shock as something that may have a one-off impact on the price level but not a persistent impact on inflation. That would be to resurrect the ‘team transitory’ debate of 2022. It is, though, hard to make progress standing still and we may get very wet while the rain falls. This is where clear central back communication strategies are so incredibly important just now. We do not know how long the disruptions will last so there is great sense in waiting for more data and news on the progression of the war before acting. But, meanwhile, it seems attractive to me to develop a dominant narrative that emphasises central bank anti-inflation vigilance, an awareness of the financial risks and a reminder of overwhelming preparedness to provide multilateral liquidity on a swap basis if required as a response to pressures brought to bear by high volatility in market prices. 

It is not easy to walk between the raindrops without getting wet, but that is what we are asking of our nimble central banks: be prepared to act if required and state clearly that they will do so should the need arise.

Jagjit S Chadha is Professor of Economics at the University of Cambridge. He is the author of  The Money Minders: the Parables, Trade-offs and Lags of Central Banking.