Hunter: Supply shocks create monetary policy trade-offs
RBA Assistant Governor Sarah Hunter explained how supply shocks create unavoidable trade-offs for monetary policy. Speaking at the Australian Conference of Economists, she detailed how these shocks push inflation and economic activity in opposite directions.
The unavoidable policy trade-off
RBA Assistant Governor Sarah Hunter emphasized that monetary policy is a demand management tool, unable to materially change the economy's productive capacity.
She explained that adverse supply shocks create a fundamental trade-off for policymakers: they push up inflation while simultaneously dampening demand and economic activity.
This puts central banks in a challenging position, as higher inflation suggests raising rates, while weaker activity argues for cuts.
Hunter stated, "This trade-off cannot be avoided.
A central bank can only decide how to balance the impact on inflation and activity, while ensuring that temporary shocks do not become persistent inflation.
" She noted that such shocks, rarer before COVID-19, are now more frequent due to geopolitical tensions, trade fragmentation, and climate events, forcing the RBA to navigate these complex dilemmas repeatedly.
Navigating structural shifts and shocks
Hunter outlined a framework categorizing economic disturbances into three types: slow-moving structural drivers of supply capacity, shorter-term cyclical demand shocks, and shorter-term cost or supply shocks.
She clarified that while demand shocks typically move inflation and economic activity in the same direction, creating fewer trade-offs for policy, supply shocks push them in opposite directions.
Structural changes, such as shifts in productivity or population, tend to be slow-moving and do not create significant short-term trade-offs.
However, accurately identifying these trends in real-time remains a continuous challenge for central banks.
Policy's new tightrope walk
Hunter's speech underscores the increasing complexity central banks face in a world marked by more frequent and impactful supply shocks.
It highlights the inherent limitations of monetary policy when confronted with supply-side disruptions, forcing difficult choices between price stability and economic activity.
This evolving landscape makes transparent communication about these unavoidable trade-offs essential for public understanding and managing expectations effectively.