Hjelm on monetary policy trade-offs and supply shocks

Deputy Governor Göran Hjelm of Sveriges Riksbank outlined his perspective on monetary policy in the face of supply shocks, such as those that fueled inflation in 2022 and are recurring with the war in the Middle East.

He stressed that the optimal monetary policy response depends on the shock's scale and the current economic situation.

Hjelm identified two critical factors for the Riksbank to 'see through' temporary, supply-driven inflation, like that from energy prices.

First, clear communication is essential to explain the nature of the shocks, their economic effects, and why a temporary inflation increase is acceptable.

Second, fiscal policy and wage formation must not exacerbate the risk of broad, persistent inflation.

This necessitates a well-functioning interaction between the Riksbank, politicians, and social partners.

Hjelm noted this interaction proved effective during previous high inflation periods, allowing monetary policy to consider the real economy.

Hjelm elaborated on the concept of 'seeing through' supply-driven inflation, where prices rise but real economic activity dampens.

This approach requires clear communication from the central bank to explain its tempered response, thereby maintaining long-term confidence in the inflation target.

It is crucial to distinguish between accepted direct and indirect price increases stemming from disruptions and unacceptable secondary effects, which would necessitate monetary policy tightening.

The appropriate response varies with the shock's magnitude: small, short-lived shocks may warrant no reaction, while large shocks demand tightening to prevent secondary effects.

For medium-sized shocks, factors such as inflation target credibility and initial economic conditions are key.

Hjelm cited the 2021-2022 supply shocks, which saw import prices surge by 40 percent, as an example where significant tightening by the Riksbank was necessary.