Ter Weel: Central banks must intervene in persistent supply shocks
Bas ter Weel, a DNB official, argued that central banks face a critical judgment call: knowing when to intervene in the face of supply shocks and when to "look through" them. He outlined three factors shaping the optimal policy response, including shock persistence and its transmission into broader inflation.
The parenting dilemma
Bas ter Weel, a DNB official, highlighted that central banks, much like parents, must decide when to act and when to observe when confronted with supply shocks.
While the textbook approach suggests looking through small, temporary shocks to prevent unnecessary volatility in output and employment, there are clear limitations.
"Incoming information suggests that the recent energy shock may prove more persistent than previously expected and that its effects are increasingly feeding through to broader inflation," ter Weel stated at a conference in Vienna.
He emphasized that the ECB's single mandate is price stability, but its strategy acknowledges that achieving this over the medium term helps avoid excessive output and employment volatility, especially given policy lags.
The Eurosystem's latest strategy review concluded that the appropriate response to inflation deviations is always context-specific.
Persistence, transmission, amplification
Ter Weel detailed three factors influencing policy response: shock persistence, its transmission to inflation, and amplification by the economy's state.
For persistent shocks, like demographic change, a DNB model showed that merely "looking through" by keeping rates unchanged leads to higher inflation volatility with negligible output benefits.
Even temporary shocks can have lasting effects if they propagate through production chains.
Eurosystem research, using the New York Fed's Global Supply Chain Pressure Index, found that such shocks persistently affect core inflation, with peak effects occurring months after the initial disturbance.
This delayed response further limits how long central banks can safely look through.
Finally, when inflation is already high, supply shocks are amplified due to state-dependent pricing behavior, where firms adjust prices more frequently.
This implies that linear models may underestimate the true impact of such shocks.
Beyond 'just a phase'
The speech underscores the profound complexity of central bank decision-making in an era of recurrent supply shocks.
Ter Weel's parenting analogy effectively distills the nuanced balance between patience and decisive intervention required for effective monetary policy.
This framework offers a robust lens for assessing future supply-side challenges, moving beyond simplistic assumptions of transience.