The inflation shock – taming uncertainty

The most commonly told inflation story is the following: an imbalance between demand and supply – due either to demand or supply shocks – results in too much money chasing too few goods. To bring inflation back to target, independent central banks then raise interest rates to suppress aggregate demand. As most economists recognise, this adjustment process can be painful: less investments, more unemployment, and austerity. However, so the story goes, the alternative of letting inflation stay high would be even worse.

One central question, discussed by Mark Blyth (Brown University) and Orsola Costantini (UNCTAD), was whether inflation really is worse for everyone. They pointed out that both inflation and central banks’ fight against it is not neutral but comes with distributional consequences. According to Orsola Costantini, profits usually go up while real wages tend to decrease during inflationary episodes. At the same time, it hurts creditors and benefits debtors.

Both discussants explained recent inflation with a number of supply shocks, where spikes in energy and food prices already started before Russia’s attack on the Ukraine. According to this “team transitory” version of inflation, current monetary policy could be unnecessarily harmful, as inflation would have adjusted itself, once the supply shocks were over. This is crucial, as these types of supply-(chain) shocks will likely increase in the future due to more climate-induced extreme weather events and geopolitical tensions. Mark Blyth argued that even the inflationary episode of the 70s, which is usually thought of as demand driven and government induced until Volcker stopped it by massively increasing interest rates, may have been induced by a series of additive supply shocks instead: the Vietnam war, three failed harvests, and two big oil shocks.

Considering also the negative external effects of higher interest rates on countries in the global south, a relative higher importance of supply vis-a-vis demand shocks could change the cost-benefit assessment of contractionary monetary policy. In this vein, Blyth also called the relevance of inflation expectations into question, citing the 2021 study by Jeremy Rudd.

Given that standard monetary policy by central banks might not always be the best solution, governments come into focus as possible players with policies that can limit the repercussions of future supply shocks. For example, by building buffer stocks, by giving subsidies, or by investing in the energy transition. Another policy option would be to cut the debt of developing countries as a sort of mission-oriented financial help, so that these countries can make the necessary investments in climate mitigation and adaptation policies, which would also serve as insurance against future shocks.