François Villeroy de Galhau, Governor of the Banque de France says not all supply shocks are alike and gives a cartography of supply shocks:
These multiple supply-side shocks will have different implications for inflation. Adverse supply shocks, while usually contractionary, need not be inflationary at all horizons. As a consequence, there is no ‘one-size-fits all’ policy response. The starting point is a thorough analysis of the anatomy of supply shocks, with a corresponding cartographyvi. Five key characteristics of the shock matter for monetary policy.
The first one is the degree of shock reversibility. This is why central banks may want to “look through” supply shocks, since the inflationary effect of a transitory shock might dissipate before monetary policy reaches its full effect (after 18 to 24 months). Symmetrically, as central banks can be uncertain about the transitory nature of supply shocks, they may want to react early to avoid spillovers to core inflation.
The second characteristic is between the domestic or external origin of the disruption. When the shock is imported from the rest of the world (e.g. an oil-price shock for an importing country), the impact on domestic inflation may be later mitigated by the negative impact of the terms-of-trade shock on aggregate demand. The same shock can be an external supply shock and an internal demand shock. Such mitigation of inflation is absent if the shock is domestic (e.g. a drought leading to an increase in local food prices).
The third characteristic is the centrality of the affected sectors. It determines how far shocks can ripple through the supply chain. The semiconductors shortage in 2021 is an example of an upstream shock leading to significant production losses in the downstream production of automobile around the globe.
The fourth factor to consider is the degree of price stickiness in the affected industries. Differences here interact with the sector centrality I just mentioned. Recent energy price shocks originated in a sector with fairly flexible prices. But energy is an upstream sector and shocks here are cost-push shocks for downstream sectors with overall stickier prices, including services. While inflation initially rises only in a limited way in sectors with sticky prices, it persists for longer. viii
Finally, the fifth characteristic of supply shocks is their predictability.
Disruptions do not need to be sudden and unexpected, they can be anticipated well-ahead. The more predictable a supply shock, the more manageable it will be. For instance, a preannounced steadily rising carbon tax will have more manageable effects than an unexpected one-off jump.
As no one approach fits all, central banks have to figure suuply shocks:
Bottom line: there is no longer one textbook answer to supply shocks. Central banks will have to analyse more granular data, and exert their judgment. Most shocks to come could be expected to be external for the euro area and on more flexible prices like commodities or critical raw materials, and hence have less persistent inflationary effects if inflation expectations are kept well anchored. But their centrality in the economy, and their intricacy with more sticky services prices should keep central banks in alert.
While climate-related and natural disasters are often unpredictable, risk scenarios help us to identify the worst possible outcomes and mitigate them (by reacting ahead of time).ix These could be useful input to a risk-management approach to policy setting.
That said, expect all of us to live with increased uncertainty. Frank Knight (1921) famously coined the difference between risks, which are measurable and hence hedgeable, and uncertainty, with unknown probabilities and outcomex. Today’s world is more and more “Knightean”. And uncertainty negatively impacts investment decisions as shown by Bloom et al.xi, as well as household consumption: see the recent increase in the savings rate in Europe, at least partially explained by a lowering confidence. Central banks themselves won’t fully escape this increased uncertainty; but they must do their best, as “uncertainty absorbers”, to reduce it for economic agents: this brings me to our inflation objective.
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