Understanding inflation and Central Bank policy choices¶

October 2022: The job of central banks in recent years is like riding a rollercoaster. After having to fight with deflationary forces arising from the financial crisis in the late 2000’s and from the 2020-2021 COVID-19 pandemic, inflation became the number one public enemy during 2022. Several shocks that range from the disruption in global production supply chains to increasing commodity prices due to the Ukraine war have increased consumer price (CPI) inflation to levels incompatible with central banks’ mandate of price stability (see Figure 1). The frequent headlines of the ‘cost of living crisis’ refer to the fact that workers were not on average receiving nominal wage rises to compensate them for the rising inflation.

Figure 1: Consumer price inflation in the EU 2009-2021. Source: Eurostat

Central bankers may yearn for past too-low inflation scenarios where, if successful, monetary policy could help the economy avoid or escape a deflation trap and produce both price stability and lower unemployment. Instead, when negative supply shocks - like an oil shock - hit the economy central bankers face a nasty trade-off between price stability and unemployment, at least in the short run. Bringing inflation down to hit the central bank’s target in the short run is technically possible but, is it worth the economic downturn and the increase in unemployment that this would entail? Most central banks consider that it is not since they take the inflation target as a medium run goal. Within this time frame central banks face two uncertainties that condition their decision.

• First, how persistent are the underlying shocks and/or may there be in the near future counterbalancing disinflationary shocks?
• Second, how anchored are inflation expectations to the central bank’s inflation target and how serious is the danger of second round effects?

A tight disinflationary policy could produce needless suffering if the underlying inflationary forces dissipate in the near future. However, a too timid response of monetary policy to inflation may trigger de-anchoring and second round effects that would push inflation further away from the target.

This interactive simulation can help you to understand some of the monetary policy dilemmas faced by central banks in the wake of the pandemic and the war in Ukraine explained above.

• All the sections share the common feature of representing an economy hit by an inflationary supply shock (think of an oil price shock).
• First, as a benchmark, the consequences of the shock for inflation are shown assuming that monetary policy is passive and that expected inflation is equal to last period’s inflation, i.e.inflation expectations are not anchored to the central bank’s inflation target. .
• In the second section you take charge of monetary policy and use your interest rate choice to change the consequences of the shock for the first period after the shock. Here you will experience the short run trade-off implied in this monetary policy decision.
• In the third section you can compare the no-policy reaction benchmark with two alternative monetary policy paths: an active but too timid monetary policy and one that succeeds in reducing inflation. .
• In the fourth section you can put yourself in the skin of central banks with different degrees of inflation aversion to see that optimal monetary policy is compatible with different degrees of tightening.
• Finally, the last section introduces inflation anchoring for the first time. It reveals why anchoring inflation expectations is so important to central banks because it allows monetary policy to bring inflation back to the target quicker and with lower unemployment costs.

The supply shock¶

When the price of imported energy and or commodities goes up, certain goods such as fuel or food become more expensive for the consumer. Costs of production go up as well and firms try to pass-through these higher costs to final prices. According to the model, firms are able to protect their profit margins by passing on these cost rises.These effects happen relatively quickly and concentrate in the first period, as shown in the figure below (Fig. 2). What happens in the following periods depends on policy. In the following sections you can explore different policy options and scenarios.

Figure 2: Consumer Price Inflation rises from 2% to 5% following the oil shock

No policy reaction¶

If there is no policy response to the rise in inflation caused by the oil shock, the situation quickly spirals out of control as inflation rises period by period (Fig. 3)

Figure 3: The case of an oil price shock with no policy reaction - inflation rises period by period

When the price of oil increases, inflation goes up in the shock period due to the increase in the price of fuel for consumers and the pass-through of the increase in firms’ costs to final prices. This increase in inflation has two effects relevant for next period, assuming the economy was at equilibrium employment with inflation at target to begin with.

• First, it reduces the purchasing power of workers, which means that workers’ real wages are below the level consistent with the state of the labour market. In the WS/PS model, the PS curve shifts down. This means that at the initial employment level, the real wage they get shown by the new lower PS curve, is below the real wage they need to be paid to show up and provide the required effort for the firm.
• Second, the increase in inflation increases inflation expectations for the future. This is due to the assumption that expected inflation is equal to last period’s inflation. The Phillips Curve (PC) shifts up.

Due to these two effects, in the next period, nominal wages increase faster both to offset the loss in purchasing power due to the unexpected increase in past inflation and to avoid erosion of purchasing power due to higher expected inflation. Wage setters are frustrated in the attempt to restore the real wage to its initial level, which was on the WS curve (and on the initial PS curve). Firms pass on the increase in unit labour costs arising from the rise in nominal wages to final prices to sustain their profit margin, increasing inflation above expected inflation. Therefore, in each period thereafter the attempt to restore workers’ purchasing power will maintain nominal wage growth and inflation above expected inflation, fueling an inflation spiral.

Test yourself¶

1. You can verify that choosing the appropriate interest rate, the central bank manages to bring inflation back to target. But could the central bank do even better, in terms of inflation? Discuss whether the central bank could avoid the increase of inflation in the shock period. Why or why not?
2. Answer the following questions:
   1. Choosing different values for the interest rate, try to gauge the sensitivity of GDP with respect to the interest rate and the slope coefficient for the Phillips curve (hint: both are integers).
   2. There is evidence that the Phillips curve has flattened during the lasts decades (see, for instance, Prospects for inflation: sneezes and breezes (europa.eu)). Discuss how the flattening of the Phillips curve may affect the cost of bringing inflation down after the supply shock.

2. Comparing different reactions by the Central Bank to an oil shock¶

In response to an inflation shock, a Central Bank could have different approaches to recovery - each with their own costs and benefits over both short and long term.

Use Figure 5 to explore the whole path of the economy following different policy choices.Look first at the path of the real interest rate to see what the Central Bank does; then look at the outcomes for the economy.

Test yourself¶

Consider the following words taken from a 2022 speech by Jerome Powell, chairman of the US Federal Reserve:

"Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.(…) During the 1970s, as inflation climbed, the anticipation of high inflation became entrenched in the economic decision making of households and businesses. The more inflation rose, the more people came to expect it to remain high, and they built that belief into wage and pricing decisions. (…) History shows that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes more entrenched in wage and price setting. The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now."

After reading the text, answer the following questions:

1. What do you think Mr. Powell means with "softening of labor market conditions"?
2. Which of the two active policy scenarios ("Central Bank that slowly accepts change to unemployment" and "Central Bank that accepts costly recession and unemployment below equilibrium to prioritise inflation") better fits the 1970’s experience described by Powell? Why?
3. Which of the two active policy scenarios better fits Jerome Powell’s intentions in 2022? Why?
4. Consider scenario number 3 where the central bank quickly reacts to the shock. You can see that in this scenario the interest rate and the unemployment rate peak to 5,5% and 9%, respectively. Now consider scenario number 2 and let us imagine that in period 15 the central bank resolves to tighten monetary policy in order to bring inflation back to the target. How tight should monetary policy be compared to scenario 3 (more/less)? How much unemployment would it cause compared to scenario 3 (more/less)? Why? Which part of the text can help you to answer these questions?

3. A Central Bank with an explicit loss function and inflation target (2%):¶

The impact of the policy maker's aversion to inflation.

Now that it's clear how a costly recession is necessary, we introduce the variable ‘beta’. Beta reflects the extent to which the Central Bank prioritises inflation control over growth/employment.

In the previous section we saw that an oil shock implies a trade-off for the central bank between inflation and unemployment. In this section we show that the way this trade-off is dealt with depends on the central bank’s degree of inflation aversion. The central bank uses the monetary rule curve to determine its interest rate reaction to the shock.

A benchmark is set where the central bank places the same weight on deviations of inflation from its target and of unemployment from equilibrium. This implies that beta is equal to one in the central bank’s loss function.

Test yourself¶

Compare the monetary policy reaction to the shock by two central banks with very different beta (for instance, beta=4 compared with the benchmark). Explain in words why with higher beta:

a. The peaks of the interest rate and of unemployment are higher

b. The central bank relaxes policy quicker and unemployment falls quicker to its new equilibrium. (hint: it has to do with inflation expectations)

4. Experimenting with different inflation expectation formation processes: Anchoring vs Inertia¶

Inflation recovery is not just dependent on the Central Bank's reaction.

How households and firms form their expectations about inflation affects their behaviour, and their own reaction to changing interest rates. Both the way these expectations are formed and the proportion of the population who share the same expectations, shape the economy's recovery from a shock.

To this point, inflation expectations have excluded any anchoring to the central bank’s target. Anchoring of inflation expectations relaxes the short run trade-off between inflation and unemployment that the central bank faces when dealing with an inflation shock.

The case with no anchoring is set as a benchmark and it matches the cases considered in previous sections (i.e. expected inflation is equal to last period’s inflation).

With higher anchoring, inflation expectations are less affected by the initial upsurge in inflation. Therefore, the central bank needs to increase the interest rate to a lesser extent to achieve their aim of calming inflation. This results in both a lower short run increase in unemployment and a faster return of inflation to its pre-shock level. In the extreme case when there is full anchoring, the central bank just needs to adjust the interest rate to its new equilibrium level from the very onset in order to drive inflation back to its pre-shock level.

Test yourself¶

1. Choose different levels of anchoring and notice how anchoring improves macroeconomic outcomes of monetary policy. Explain with your own words why central banks like a high level of anchoring. Speculate about how a central bank can improve the degree of anchoring.

2. Consider the case of full anchoring (level of anchoring=1). See that the central bank increases interest rate to its new equilibrium value equal 4% and inflation falls back to the target in just one period. Now, in this context of full anchoring, speculate about the consequences for inflation and unemployment of not changing the interest rate after the shock…

     a. …first, considering that full anchoring remains.

     b. …second, discuss whether full anchoring may be in danger if the central bank persists in its passive monetary policy and the future implications for inflation.

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