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Suppose there is a very large increase in the world price of an important good which is essential for many people, such as the increase in price of natural gas over the last year or so.

Considering price inflation in a country which imports a large quantity of that good, it would still be mathematically possible for the average rate of inflation to be zero or very low if the increases in the price of most other goods are sufficiently low, and in some cases negative.

Question: Is it possible in those circumstances that a suitable monetary policy could keep the average rate of inflation very low, and if so would there be any adverse consequences (eg on GDP or employment) of such a policy?

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  • $\begingroup$ When you say "average inflation", I assume you refer to the average across items in the basket and not across time, right? $\endgroup$
    – BrsG
    Aug 11, 2022 at 8:15
  • $\begingroup$ @BrsG Yes, average (appropriately weighted) across items in the basket. $\endgroup$ Aug 11, 2022 at 13:03

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When a central bank tries to achieve price stability, it always has to make a trade-off between price stability and, consequently, better medium- to longer-term economic performance and short-term economic costs, either explicitly or implicitly, depending on exactly what its mandate is.

There is little that a central bank can do to control imported inflation. However, the longer high imported inflation persists, the more likely it is to feed into domestic inflation dynamics (via the production chain and price and wage formation). That's why central banks focus on (market and household) expectations of domestically generated inflation.

The higher the prospects for medium-term inflation in the absence of intervention, the more beneficial it is, in their view, to trade short-term costs for low medium-term inflation through intervention. In this sense, the aggregate (or net effect) of short-term costs and longer-term benefits is indeed positive, at least in their view, even if the short-term costs are substantial in absolute terms.

Given the lags with which monetary policy affects the economy (a rule of thumb is 6-18 months) and an inherently uncertain future (who in January 2022 would have expected Russia to invade Ukraine in February?) it is impossible for total inflation to always match the target.

This would only be "possible" if a central bank had perfect foresight, at least over the period in which policy affects the economy. In particular, it would have to be able to perfectly anticipate all external shocks, the way they are transmitted domestically, and the transmission of its own policies.

In this hypothetical situation, massive interest rate hikes would be needed to pre-empt an upward deviation of inflation from target. The reason is that the central bank would offset imported inflation by lowering domestic inflation proportionally, which would most likely be negative (depending on how high imported inflation is).

Example: Assume imported inflation is only due to energy imports whose prices have risen 42%, while domestic inflation runs at 2% Assume energy makes up 20% of the CPI basket. Without intervention that makes for 10% total inflation [$0.2\times42 + 0.8\times2 = 10$]. In order to achieve 2% overall inflation, domestic inflation would have to be -8% [$0.2\times42 + 0.8\times(-8) = 2$].

Since so much more policy tightening is required to bring total inflation, not just domestic inflation, under control, the intervention would have a much higher economic cost than if only domestic inflation were targeted. More importantly, it would be "overkill." An otherwise healthy economy can well tolerate an occasional increase in imported inflation as long as it is temporary.

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    $\begingroup$ @AdamBailey: I have edited the answer and made the example more explicit. $\endgroup$
    – BrsG
    Aug 11, 2022 at 13:58
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Question: Is it possible in those circumstances that a suitable monetary policy could keep the average rate of inflation very low, ...

This is in principle always possible assuming a central bank (CB) would be willing to do whatever it takes (no pun intended) to bring the inflation down.

Whereas, when it comes to generating sufficient inflation, CBs might run into some problems due to zero lower bound, there is no upper bound on how high interest rates can get. In addition, CBs can also tighten lending standards, roll back the new ample reserve new normal, heavily sell the government bonds their hold and refuse to buy more. All of the above put downwards pressure on aggregate demand. If a CB would be dedicated to go far enough it will eventually lead to drop in aggregate price level.

and if so would there be any adverse consequences (eg on GDP or employment) of such a policy?

This depends on the parameters of the economy. It would almost certainly lead to drop in output and employment in the short run. In the long run AS curve is thought to be vertical so unless the drop in output and employment triggers hysteresis (e.g. see Garga & Singh 2021) it should have no effect on output and employment. However, if it leads to some hysteresis it could lead to persistent drop in output and employment.

As mentioned at the beginning the answer here would be quite sensitive to the parameters. If CB has to hike interest rates by 3% clearly the effect won't be as large as when it has to hike interest rates by 20%. You do not specify any parameters for your scenario so not much more can be said.

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