Vladimir Putin’s assault on Ukraine has silenced last year’s “transitory versus permanent” debate over the global rise in inflation. The economic effects of the war will be huge everywhere, and the behaviour of inflation will reflect those consequences as much as reveal who was right beforehand.
That disagreement still matters, however. Where central banks came down on the question before the war has implications for how they must think about handling its effects today if they want to be consistent.
Recall that accelerated inflation in 2021 arose from Covid-related production disruptions in global value chains, leading to relative shortages of manufacturing inputs and commodities. There can be reasonable disagreement about whether to tighten monetary policy in the face of a negative supply shock, when inflation occurs because the economy’s productive potential has been damaged. A central bank could judge that this type of inflation should be ignored if the supply shock involves a temporary adjustment in relative prices after which the price level stabilises by itself.
Last year, however, this side of the argument lost out inside the major central banks. The Federal Reserve, the European Central Bank and the Bank of England all made clear hawkish turns. By adopting that stance then, they painted themselves into a corner.
The war against Ukraine brought a new negative supply shock on top of the old one, adding both to the drag on growth and the upward pressure on prices. Hawkish signals in response to a first supply shock logically committed central bankers to doubling down on tightening when a second one made things worse.
Monetary policymakers everywhere are promising that their decisions will be “data-dependent”, but how they interpret incoming data is what matters. So far, major central banks have eschewed the opportunity to use the shock of Putin’s invasion to restate how they think about the economy.
How should they do this? First, by better explaining their thinking around negative supply shocks. Are they really committed to tightening more and faster, the worse the shocks buffeting households and businesses get?
Second, central banks should clarify how they think their monetary policy works. Presumably, the point of reducing monetary stimulus is to take the wind out of the sails of demand in the economy, so as to bring it down to the damaged supply capacity. This was already hard to justify, given that nominal spending had only barely returned to pre-pandemic trends in the US and still fell short in the eurozone and the UK — hardly “excessive” demand.
Do central bankers really think the most severe war in Europe in a lifetime, where the aggressor is the region’s most important commodity exporter, calls for pressing the brake harder on their own economies’ growth?
Third, they should be addressing head-on the novel nature of these supply shocks. The Covid lockdowns caused an unprecedented sectoral reallocation in the US. Durable goods spending is still some 25 per cent above its pre-pandemic trend; on nondurable goods it is roughly 10 per cent higher. Services spending remains correspondingly depressed.
While the pandemic did not cause a dramatic reallocation of spending in Europe, the war on Ukraine may.
The prospect of a sharp fall in fossil fuel supplies from Russia — a coal embargo is already scheduled, and the pressure is strong for oil and gas to follow suit — will, after all, force a significant shift away from production and consumption that use such resources intensively.
Such needs for (possibly permanent) reallocation complicate standard arguments about how monetary policy should treat an inflationary supply shock. A recent paper by Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub and Iván Werning shows that if keeping interest rates low makes reallocating resources easier, the optimal stance for a central bank is looser than it would otherwise be. Thus, if it is clear that labour and capital must move from one sector to another — and the faster the better — how can it possibly be right to tighten monetary policy, making investments in new capacity both more expensive and less attractive as demand growth slows?
A simple answer would be that this is no concern of central banks responsible only for controlling inflation. But that would be wrong — and not just because central banks have more tasks than this. Since insufficient reallocation means lower productive potential in the future than could otherwise be had, it also means an overzealous fight against inflation today will either raise inflation in the future or increase the cost of keeping it low.
What these questions together amount to can be put more simply. Today a pandemic, a war and a climate crisis all necessitate huge structural shifts — which may themselves maximise potential productivity and minimise long-term inflationary pressures. In such a situation, how could it be right for central banks to delay investment and jobs growth, and with them the needed reallocations?
Until central bankers can answer that question convincingly, they should be less eager to tighten.
