Supply side shocks upend macro policymaking

In financial economics the four most dangerous words are “This Time is Different”. Each time one thinks that the financial markets are well placed and there will be no crisis as “this time is different”, there is a crisis soon thereafter. Likewise, in general economics each time someone says an economic idea is no more relevant, it comes back to haunt the economy.  Such is the story of supply-side inflation which was seen as being in coma only to make a strong comeback pushing inflation worldwide.

Theory of inflation

Economics textbooks note that inflation is due to two factors: demand pulls inflation and cost pushes inflation. Demand pull inflation, or demand shock, is due to an expanding economy which leads to higher demand for goods and services. In case the rising demand is higher than production, it pulls the economy into a wider inflation. Cost push inflation, or supply shock, is due to some external shocks such as war, drought etc. which lead to higher prices of raw materials and wages. The higher wages and costs push the economy into wider inflation.

Economics models convey that policymakers find it easier to tackle demand shocks compared to supply shocks. In case of demand shock, both output and prices move in the same direction. Say economic growth picks up leading to higher demand for goods and services. This leads to both higher growth and higher inflation. If the policymakers act, it brings both growth and inflation lower.

In case of a supply shock, we see that output and prices move in opposite directions. Say there is a war leading to higher costs. This will lead to higher inflation and lower output. Here, policymakers are in a bind. If they increase output, it leads to higher inflation. Likewise, if they lower inflation, it leads to further contraction of economic activity.

Practice of inflation control

Economic history suggests that mostly economies face demand shocks mainly due to higher government expenditure.  The governments are often tempted to increase government spending to boost growth due to political pressure, stoking higher inflation. Hence the need for autonomous central banks who tighten monetary policy to keep inflation in check. This combination of loose fiscal policy and tight monetary policy leads to the classic saga of conflicts between governments and central banks.

However, occasionally economies face supply side shocks as well. In the 1970s, the twin oil crises pushed inflation upwards in most countries in the world. The policymakers were caught in the supply shock trap of high inflation and low growth (also called as stagflation). They were initially reluctant to allow growth to go lower leading to even higher inflation. It finally required a very tight monetary policy by Paul Volcker, then Chair of the Federal Reserve to bring inflation back to control. However, a tight policy also meant pushing the economy into a recession.

The high inflation of the period and its eventual control led to the rise of the monetarism school of thought. Monetarism implied that inflation is a byproduct of high growth in money supply. Central banks and monetary policy, which so far played second fiddle to governments and fiscal policy, now became the centerpiece of macroeconomic strategy.

All these years, the world economy mainly dealt with demand side shocks where central banks were simply expected to tweak interest rates to bring inflation back to control. The developing countries did face supply shocks but the causes were seen as inefficient supply chains, poor agricultural systems and so on.

Supply shocks today

Fast forward to the 2020s; supply shocks are making a strong comeback.

François Villeroy de Galhau, Governor of the Banque de France, in a recent speech, said that not all supply shocks are alike. He classified supply shocks across five categories with each being more, or less, inflationary. For instance, some supply shocks are transitory and others permanent. The bottom line is supply shocks are different and require deep analysis by central banks to determine actual causes of inflation.

In terms of policy, central banks will have to keep a medium term orientation. A central bank is not required to react to short-term price deviations but only if inflation is likely to be persistent over time. While there is temptation that policy focuses on core inflation, de Galhau says one should stick to headline inflation as it is easier to communicate.

Lessons for India

How do lessons of this long history apply to RBI and India? Developing economies like India have constantly faced supply shocks.

The Government has given RBI an inflation target of 4 percent with a band of +/- 2 percentage points. The band confuses markets as one is not sure whether the inflation target is 4 percent or 6 percent. However, due to these continuous supply shocks it helps RBI to not react to short-term price changes. There were discussions that RBI should lower interest rates when inflation touched below 4 percent in July 2024 and August 2024. However, RBI decided not to cut policy rates as it was seeing supply shocks to continue. In October 2024 inflation touched 6.21 percent.

There was also a lot of discussion on whether RBI should switch to core inflation. But it will be difficult given communication challenges.

RBI is also engaging in deep analysis of supply shocks. In October 2024, RBI released four research papers studying price movements of key commodities that drive inflation.

To sum up, supply shocks have made a strong comeback to complicate macroeconomic policy. In a world already struggling to generate growth and lower inflation, supply shocks only lead to higher inflation and lower growth. Going ahead, macro policymakers have their hands full.

Authored by Amol Agrawal. Amol teaches at Ahmedabad University. 

Views are personal, and do not represent the stand of this publication.