Global Price Shocks: How Central Banks Should Respond to Crisis

The surge in energy prices that followed the geopolitical collapse of peace in the Middle East, together with the acceleration of both actual and expected inflation, is a fresh reminder that the world faces formidable challenges. The global erosion of supply chains has taken yet another blow. First came the Covid crisis and the breakdown of familiar logistics routes; then Russian aggression against Ukraine, which delivered a powerful jolt to energy prices that were already rebounding briskly after the restrictions of 2020; then Trump’s tariffs, which redrew trade flows; and now the blockade of the Strait of Hormuz, choking global supplies of oil, gas and refined products. The sheer frequency of these global stresses is fundamentally reshaping the landscape of economic stability worldwide. Coupled with the pessimism about any easing of geopolitical tension, central banks now confront a world in which unprecedented volatility and uncertainty have become the norm, demanding clear rules of conduct for navigating an unstable environment.

The inflationary shock of 2021–2023 has likewise left a deep imprint on the collective memory of central banking. The reappraisal of monetary strategy by the European Central Bank, the Federal Reserve and a host of other monetary authorities—prompted by the destructive fallout from the sharpest price rises in four decades—showed that safeguarding macro-financial stability in an unpredictable environment calls for a far more conservative approach than any flirtation with monetary flexibility, however apt such flexibility may have seemed when inflation could barely lift itself out of the 1–2 percent range. Both in the rethinking of monetary strategy and in the wider body of research, a consensus is at last beginning to take shape about the optimal response of central banks to shocks—above all those tied to global commodity prices.

Macroeconomics works with two principal kinds of shock. A demand shock is a situation in which output (production) and prices move in the same direction. A supply shock, by contrast, is one in which output and prices move in opposite directions. The difference in nature between the two is of fundamental importance for monetary policy. In the first case, the response of a central bank that seeks to maintain price stability alongside durable long-run growth is self-evident: raise rates when demand is overheating the economy, cut them when the economy slows and price pressures ease with it. Simple enough. With supply shocks, however, the picture is far less clear. The plausible assumption that a rate rise can do little to influence prices driven up by a contraction in supply has become an invitation to the theoretical inferno of macroeconomic debate—and a veritable paradise for fault-finders. Their carping rests on the conviction that the final truth about the correct monetary response to supply shocks is plain only to enlightened experts, omniscient academics and true champions of faster growth, while the witless central banks remain in the dark and must therefore have their eyes opened, again and again, through aggressive political posturing. Such critics even have a lexicon of their own, in which “cost-push inflation” functions as something close to holy writ. Oddly enough, macroeconomic science does not actually use the term “cost-push inflation”; it speaks instead of “cost-driven price pressure.” The wage-price spiral is the most dangerous and most extreme example of such pressure, yet in macroeconomic terms it is not a pure supply-side shock. In an economy, incomes are the mirror image of costs, so a rise in wages is at once a rise in costs and a rise in incomes.

Orthodox macroeconomic theory therefore holds that a supply shock should be ignored, since reacting to it makes the outcome worse. Price pressure does not subside of its own accord, while demand is squeezed, slowing supply still further. A central bank that tries to dampen the swings in both inflation and growth at once fails to achieve what it set out to do. It is precisely this conclusion that has hardened into a kind of stereotype—wrenched from its context and turned into something of an ideology. In reality, the situation is far more complicated.

First, by no means every instance of cost pressure is a classic supply shock. To put it another way, the very existence of a supply shock has to be demonstrated—and that is far from straightforward in real time. Working with aggregate data, separating demand shocks from supply shocks requires theoretically grounded assumptions and the use of sophisticated macroeconomic modelling techniques. Markets are buffeted by several factors at once. Take the behavior of oil prices. By no means every rise in the price of oil is caused by a fall in its supply to the global market (see figure 1).

Second, what looks like cost-side price pressure for a single country may, on a global scale, be a case of expanding demand, of a benign macro-financial climate or, conversely, of a sharp rise in the premium charged for geopolitical risk and uncertainty. Figure 1 shows clearly that episodes in which oil prices rose without any fall in output far outnumber those in which they rose because output declined. In other words, the swings in global commodity prices (and not in oil alone) greatly exceed the swings in volumes produced—meaning that they contain a powerful element of overreaction. Global macro-financial conditions (the level of interest rates, the size of spreads, the behaviour of asset values, the availability of cross-border financing, the state of liquidity and so on), together with geopolitical risks, do far more to unsettle the prices of primary resources through the demand channel. That is precisely why monetary instruments are effective at the collective level, even when this is not always obvious from the vantage point of any one country.

Third, in real time demand shocks and supply shocks may be at work simultaneously. What is more, the pass-through from commodity prices to consumer prices is not static but depends on many factors. The speed at which prices adjust varies, shaped by market structure and the competition supplied by imports. And no less important are expectations. The character of expectations will determine how far cost-side pressure can be passed on to the consumer, and how far the consumer will regard such pass-through as justified. For central banks this is decisive, because it is the character of expectations that will dictate whether a supply shock proves transitory or, instead, ripples along the chain of economic linkages and shifts the entire schedule of prices in an unwanted direction. Taken together, it is vital for central banks to draw a clear distinction between the natures of different shocks, and to establish whether cost-side pressure is confined to particular markets or is spreading across the whole economy. Where price pressure stays localized, the assumption of a transitory shock may well hold: prices move out of step with one another, and inflation expectations remain largely undisturbed. Where price pressure spreads, the picture changes. Price rises become synchronized, the pressure becomes prolonged, inflationary inertia builds, and inflation expectations come unmoored.

In Ukraine, one often hears that the National Bank should do what the leading central banks do: they do not raise rates in the event of “cost-push inflation.” Without dwelling on how fanciful this model for imitation really is, it is enough to note that the leading central banks in fact offer an excellent example of how responses to price shocks are actually conducted. Figure 2 shows that the monetary institutions of the advanced economies do raise interest rates in response to pressure from rising global energy and food prices.

The habit of responding gently to acceleration in the most inflationary global prices took hold in the period between the global financial crisis and the Covid crisis, when the economy was laboring under deflationary risks and interest rates hovered near zero. Before the global financial crisis, by contrast, higher rates also allowed for a more pronounced response to global price pressure. The episode of 2021–2023, meanwhile, was marked by a somewhat different pattern of response: the rise in energy and food prices was ignored at first, but the subsequent reaction to accelerating inflation was aggressive. It was the very speed with which the leading central banks raised rates that made it possible to stabilize inflation expectations quickly and to turn the commodity-price trend around.

In other words, one may talk about “cost-push inflation” as much as one likes, but without decisive monetary action there is no way to secure price stability or to create better conditions for economic growth.

Years of research into the optimal central-bank response to inflationary shocks, together with the painful experience of 2021–2023, have laid the groundwork for a consensus on how monetary policy should respond to cost-side price pressure.

Inflation expectations matter. Rational expectations make it possible to ignore a supply-side shock, but only on condition that economic agents clearly grasp the temporary nature of the price surge and trust the central bank’s capacity to take forceful action to stabilise inflation. Other kinds of expectations—often a more realistic reflection of human psychology and economic behaviour—call for a response to mounting price pressure before a strong inertial component turns it into a drawn-out problem of elevated inflation.

The anchoring of expectations. When inflation expectations are firmly anchored and pulled, as if by gravity, towards the central bank’s inflation target, it becomes possible to ignore supply shocks, or to respond to them more gently. But where inflation expectations are prone to drift and sensitive to worsening forecasts and to non-economic factors, the central bank is better advised to react sooner to any sign of inflationary pressure.

The level of inflation and its distance from target. The higher inflation runs, and the further it strays from the central bank’s target, the greater the likelihood that even a modest supply-side shock will spread rapidly across the whole economy. High inflation is also a signal that the economy is operating close to, or above, its potential capacity. In such conditions, prices respond more sharply than output does to restrictive monetary decisions. The reverse holds too: if the economy is in a zone of low inflationary pressure and is running well below potential, cost-side price pressure may be ignored, or the response to it deferred.

The nature of monetary transmission. Where monetary transmission works well, a central bank can afford to react more slowly and later because the lags between its decisions and changes in the behavior of macroeconomic variables are shorter. Where transmission is sluggish, however—owing to excess liquidity in the banking system, a concentrated banking market and the like—the response must be both quicker and more substantial.

The relationship between inflationary pressure and the economy’s deviation from its potential. This relationship is traditionally thought to be governed by the position of the business cycle. But global structural factors exert their influence too. The more open an economy is, and the more deeply it is woven into global supply chains, the less its inflationary dynamics are determined by its own cyclical position. Inflation expectations and global supply-side shocks come to play a larger part. For central banks, then, what matters is an understanding not only of how the national economy is integrated into the global one, but also of the processes unfolding within that wider economy.

The sheer complexity of the forces behind the behaviour of inflation means that, very often, leaving the central bank’s rates unchanged is itself the well-founded answer. Unpopular rate rises, by contrast, demand extra effort to communicate the reasoning to stakeholders. The transparency of monetary institutions is meant to make plain how the chain of argument behind a monetary decision is constructed—decisions whose purpose is to explain and to persuade, and, through that, to shape economic behavior.