Nicholas C Garganas: Macroeconomic management in an environment of
aggregate supply shocks - lessons from recent experience
Background paper to speech by Mr Nicholas C Garganas, Governor of the Bank of Greece, at the
SEANZA Symposium, Bank Negara Malaysia, Kuala Lumpur, 25 November 2006.
* * *
The issue that this background paper addresses concerns macroeconomic management in the face of
supply side shocks. While the main focus is on monetary policy reactions the paper will also touch
briefly on the possible roles of other policy responses, as well as issues related to the policy mix.
Supply-side shocks have played an important role in shaping the economic history of the global
economy over the last 40 years or so. The most common supply-side shock, familiar to both
economists and non-economists alike, has been that associated with variations in the price of oil.
However, other examples include shocks to total factor productivity, arising from innovation and/or
technical progress. A recent example of this type of shock is the technology boom of the late 1990s in
the US, leading to the creation of the so-called 'new economy'.
Some theoretical considerations
Supply-side shocks affect production and, therefore, both potential and actual outputs. Consider, first,
the effect on potential output. A negative supply shock (eg an increase in the price of oil or a
slowdown in productivity) reduces the potential output of an economy for given levels of inputs and the
price level. Alternatively, it increases prices for a given level of output. As production costs rise, profit
margins are squeezed and, in an attempt to maintain mark-ups, firms raise their prices. For a given
level of demand, therefore, the negative supply shock leads to a fall in output and there will be upward
pressure on the price level.
If the upward pressure on the price level is not accommodated by the monetary authority, it will lead to
negative demand effects, causing actual output to fall. Moreover, supply-side shocks may induce
additional demand effects if, as is likely, consumers and investors are forward looking. These demand
effects will be larger the more permanent the shock is deemed to be. A permanent fall in potential
output is likely to generate pessimistic expectations of future income and wealth, causing consumers
to cut back on expenditures. The decline in the real rate of return on investment will lead firms to
invest less. This effect might be particularly strong in the case of a negative supply shock that arises
from a slowdown in the rate of technological progress. Additionally, firms may feel the effect of
increased financial constraints as falling profits reduce the amount of funds that can be generated
internally.
Thus, negative supply-side shocks can cause declines in both potential output and actual output. That
growth will slow or, perhaps, turn negative, other things being equal, is not in doubt. What is less clear
is what the ultimate effect will be on the price level (or, more generally, inflation). Initially the difference
between actual output and potential output, the output gap, is likely to be positive, generating
inflationary pressures. However, once the demand effects begin to bite, the output gap will narrow and
inflationary pressures subside.
At this point, it is perhaps worth noting that the impact on prices or inflation may differ depending on
the source of the negative supply shock. In the case of an oil price shock, the impact on inflation is
likely to be greater than other shocks. Aside from being an important input to the production process,
oil is also a consumption good and hence its price feeds directly into consumer prices. Prices may
also increase to the extent that workers resist the erosion of their real wages by seeking higher
nominal wages that must be reflected in the prices of goods and services they produce. This
behaviour generates a second round of price increases, resulting possibly in a wage-price spiral.
Wage-price spirals are a special concern to policy makers since they are likely to amplify the initial
impact of an oil (or any other) price increase. The timing of such second round effects depends
crucially on such factors as the average duration of the wage contract and the inclusion of "escalator
clauses" in contracts. Evidence from the US and Europe suggests that this time lag is around one
year1 in those currency areas.
The above analysis leads to the conclusion that policy makers face a particularly difficult challenge
when dealing with supply-side shocks, unlike demand shocks, which influence both growth and
inflation in the same direction, thereby simplifying somewhat the policy response. A negative supply
shock tends to reduce growth (perhaps even causing it to become negative), while increasing inflation.
Thus monetary policy faces a trade-off; if the authorities seek to maintain real economic activity, they
will risk setting off an inflationary spiral.
An important consideration when deciding on the policy response is whether the shock is expected to
be permanent or temporary. A temporary shock is unlikely to warrant a policy response provided
consumers, investors and policy makers recognise that the shock will be short-lived. In the case of a
temporary shock, an imminent recovery will be expected so that the additional demand effects are
unlikely to materialise; at the same time any fall in potential output will be temporary. In these
circumstances, a response from monetary policy would be inappropriate. The impact of the shock may
well have dissipated by the time that the impact of the monetary policy actions is felt. In other words,
the long lags associated with monetary policy make it unsuited for fine-tuning the economy to smooth
the effect of temporary shocks.
By contrast, a permanent supply-side shock will lead, at least in the short run under conditions of
inflexible wages and prices, to the challenge identified above - that is, dealing with lower growth and,
most likely, higher inflation. The response of the monetary authorities will depend on their goals. One
possible policy framework, although not the one followed by the ECB, is a Taylor rule under which
specific weights are assigned to both inflation and growth in formulating monetary policy. One could
imagine a situation whereby the interest rate remains essentially unchanged in the short run - the rise
in the rate necessitated by the increase in inflation being exactly offset by the reduction necessitated
by the fall in growth. In practice, however, it is more likely that the interest rate will rise, given the
emphasis most central banks place on price stability in the medium term. A rise in the policy rate also
has the advantage that it might keep the lid on possible second round effects if the source of the
shock is an oil price rise. What is crucial here is the focus on price stability in the face of shocks. By
maintaining price stability, central banks can help ensure that actual output returns to its potential level
without the distorting price signals provided by rising inflation.
In the long run, though, a permanent negative supply shock will lead to a reduction in the equilibrium
interest rate. In such a situation, monetary policy will concentrate on the need to bring the market rate
back into line with the equilibrium rate.
Implicit in the preceding argument is that the policy maker can clearly identify both the nature of
shocks and their impact. In practice, however, things are not nearly so clear-cut. The problems
associated with measuring potential output, and hence the output gap, are well known and so there is
no need to repeat them here. An additional problem is that, even if we have what we consider to be a
satisfactory way of measuring potential output, estimates of potential output in real time usually differ
from those calculated with historical hindsight (Figure 1)2. If it is difficult to measure potential output in
general, it is even more of a challenge to measure it accurately at the time when the monetary
authorities need to make a decision. Moreover, aside from the problems of measuring potential output,
there is also the question of whether it is possible to determine whether shocks are temporary or
permanent. Clearly, the more quickly a permanent shock can be distinguished from a temporary one,
the more quickly it can be determined what, if any, the policy response should be. In practice, this
implies a continuous assessment by the monetary authorities of developments on the supply side and,
given that an assessment at any particular point in time is likely to be surrounded by considerable
uncertainty, the monetary policy response is likely to be gradual.
Experience in the euro area and the US with supply-side shocks
The discussion until this point has largely been in an analytical context. One of the basic messages to
emerge from the analysis is the fact that theory does not give us a clear lead - there are too many 'ifs'
and 'buts'. For this reason, it is useful to examine the recent experience with supply-side shocks and
to draw some lessons from this experience.
As Figure 2 shows, the oil price has climbed sharply in the last few years, from under $30 a barrel in
2003 to its high of over $70 a barrel in early August of this year. The factors contributing to this sharp
increase stem from both the demand-side and the supply-side. On the demand side, there has been
the rapid increase in the energy needs of emerging market economies, especially China and India; on
the supply side, there has been low spare capacity throughout the production chain in an environment
of geopolitical tensions. Even allowing that the price of oil has recently fallen back to below $60 a
barrel, the rise in the price of oil from under $30 a barrel represents a very significant oil price shock. It
has come at a time when both the US economy and that of the euro area have been experiencing
diverging productivity developments. Since the mid-1990s, the US has experienced a positive
productivity shock with the long-term trend in productivity having picked up significantly following
twoand-a-half decades of downwardly trending productivity. By contrast, in the euro area, the downward
trend that began in the 1970s has continued (Figure 3)3.
The responses of both the US and the euro area, in terms of inflation and output, to the oil price shock
have, until now, been subdued. The US economy has continued to expand at a robust pace. While
growth in the third quarter of this year was considerably below expectations, this outcome was
primarily a reflection of the slowdown in housing; whilst inflation rose to around 4% this summer, it has
inter alia
subsequently subsided with the Fed's recent cycle of monetary tightening having contributed
to this outcome. In the euro area, the recovery, while slow in getting under way, is now broadening
and deepening. Output this year is growing at close to, if not above, potential. Moreover, inflation,
while higher than the "close to but below 2%" definition of price stability set by the ECB, is much below
the levels experienced after the first two oil price shocks. These outcomes appear to be more modest
than the predictions of econometric models, estimated on the basis of past relationships when oil-price
shocks exerted a relatively large impact on inflation and growth. For example, euro area econometric
models predict that a 50% increase in oil prices, ceteris paribus, would add almost 0.7 percentage
point on average to CPI inflation in the first year, while reducing GDP growth by around 0.4
percentage point (Table 1)4. We have not, however, seen such large effects this time around.
Consequently, other factors appear to have worked to explain the actual outcomes following this
particular shock. This argument can be elaborated on.
In the US, the negative supply shock of the rise in oil prices has occurred at a time that the trend
growth rate in productivity has been rising, a positive supply shock. Increased labour productivity
during the 1990s came from capital deepening; after the burst of the technology bubble at the turn of
the millennium, total factor productivity took over as the main engine of labour productivity growth5. In
addition, it has been argued that Alan Greenspan, having recognised the productivity shock early on
(and certainly earlier than many others, including wage earners so that wage pressures remained
low), was able to exploit the benefits of the shock in terms of lower inflation and higher output growth
by not raising policy rates to the new, higher equilibrium rate implied by the shock in the long run6. It
has also been pointed out that deregulation of energy markets in the US has made the economy more
resilient to oil price shocks since price increases no longer have the same negative effect on
productivity that they did in the past7.
However, the US experience does not get us very far in understanding that of the euro area. The
continued decline in trend labour productivity growth, induced by both a reduction in capital deepening
and total factor productivity8, implies that the euro area was already experiencing a negative
supplyside shock when the oil price rise occurred. This situation suggests that there are factors at work,
perhaps in both the US and euro-area economies, which have helped dampen the impact of this latest
negative supply side shock. These factors include the following.
First, there is a group of factors that might come under the general heading of structural changes in
industrial economies. Some analysts point out that industrial economies are less dependent on oil
today than they were during the 1970s (see Figures 4-6). Output is now much less energy-intensive
compared to previous decades and other sources of energy have reduced industrial countries'
dependence on oil9. However, this cannot be all of the story since if the effect of an oil price rise is
proportional to the amount of energy used in production, then, other things being equal, we would still
have expected to see a sharp slowdown in economic growth as a consequence of the recent sharp
rise in prices10. Yet, there has been no such slowing in growth.
A second structural change is the increase in globalisation, which has significantly raised competitive
pressures in industrialised countries11. Aside from generating a dampening effect on prices in
industrialised countries through reduced import prices (a positive supply shock), globalisation has also
weakened the power of trade unions. This situation appears to have contributed to subdued second
round effects, helping industrial countries avoid wage-price spirals. Employers now resist wage
increases in the face of high energy prices in order that their mark-ups are not squeezed. Moreover,
international competition has reduced the pricing power of firms substantially, making companies more
reluctant to increase their prices than was the case after previous oil prices increases.
In addition to these changes to economic structures, a major factor in containing the effects of
negative supply shocks is the enhanced credibility of the monetary authorities - what we might call
changing institutional structure. Enhanced credibility can be seen as a consequence of the granting of
independence to central banks and the fact that many more central banks are now charged explicitly
with, and aim to achieve, the goal of price stability. The two major negative supply shocks of the 1970s
and the differing monetary policy reactions to them can be considered to have been decisive in
changing attitudes towards monetary policy. This experience, in turn, led to the institutional changes
just mentioned.
The oil price rises of 1973-74 and 1979-80 were both accompanied by increases in inflation and
declines in output in most industrial countries. However, the monetary policy reaction to the shocks
differed. By and large, the first oil shock was accommodated, as monetary policy was loosened, in
order to offset the negative impact on growth; in contrast, monetary policy was significantly tightened
after the second oil-price shock with the main focus of central banks on the containment of inflation12.
The non-accommodation of the second oil price rise led to a contraction of output in the short run, but
contained the inflationary impact of the shock. It can be argued that the contraction in output was
larger than it otherwise might have been since monetary policy during the second oil shock had to be
tightened sufficiently not only to deal with the second oil shock, but also to counter the inflationary
pressures that remained from the first shock. Additionally, the fact that the monetary authorities did not
aim to contain inflation during the first oil price shock implied that it was more difficult during the
second shock to alter expectations. Central banks thus faced a high cost, in terms of recessions, in
their attempt to restore price stability in the 1980s.
A basic conclusion for policy making that emerges from these two episodes is the following:
inappropriate policies in the face of negative supply shocks that exacerbate the inflationary
consequences of shocks ultimately lead to an economy paying a higher price over the medium run
than would be the case if the authorities pursued policies directed toward price stability. Inappropriate
policies in the short run make it more difficult for the authorities to stabilise the economy during
subsequent shocks13. Such a conclusion is confirmed by movements in headline and core inflation
after the first and second oil price shocks. Figure 7 shows the reaction after the first oil price shock;
figure 8 after the second oil price shock. Core inflation responded much quicker after the second
shock; this provides support for the argument that inflationary expectations had become entrenched
after the first shock, necessitating a strong dose of monetary tightening.
Another conclusion that emerges from the above discussion concerns the difficulty of conducting
policy in a world of uncertainty. Consider some of the changing relationships mentioned above. These
include the decline in the energy intensity of production, the increase in global competition, including
its effects on wage behaviour and profit margins, and the ascendancy of central-bank credibility. The
upshot of these, and other, changes is that the economic world in which we function is the best
described by a structure whose parameters are constantly changing, helping to explain why the
predictions of the models about the effects of the most-recent oil price shock have been off the mark.
The challenge for the monetary official is to operate in a way that does not depend on a fixed
economic structure based on historically average coefficients.
These lessons have been enshrined in the new institutional environment of monetary policy-making
that spread throughout industrial countries during the 1990s. By recognising the limits of using an
activist monetary policy in a world characterised by uncertainty and changing parameter values,
monetary authorities focused their attention on what they could deliver - price stability over the
medium term. Crucially, that environment gave monetary policy a new credibility and created a regime
of low inflation expectations. In such a regime, inflation is less sensitive to oil price increases. In the
context of a New-Keynesian Phillips Curve, for example, inflation depends, inter alia, on current
expectations of future inflation. If expectations are solidly anchored, then inflation will not increase in
response to a negative supply shock because economic agents will not expect a rise in inflation.
Therefore, the policy actions of the monetary authorities that aim at price stabilization, as well as the
ability of the monetary authorities to communicate their policy commitments effectively to the public,
have kept inflation expectations contained and contributed significantly to the muted response of
inflation to this oil shock.
In addition to not leading to a surge in inflation, the recent oil price shock has not led to the kind of
recession experienced during the previous oil shocks. In part, this outcome may have something to do
with the fact that the recent oil shock reflects, in part, buoyant demand for oil in the US, China and
India. Consequently, the deterioration of the terms-of-trade in oil importing countries, appears to have
been counterbalanced by higher demand for their goods from the countries that demand more energy.
However, again, the monetary policy framework and increased credibility of monetary policy help
explain the more muted output response. Central banks may face less of a trade off between output
and inflation14. Because the dynamics of inflation are strongly affected by inflation expectations, a
credible central bank has the ability to contain inflation without substantially reducing output, since the
knowledge that action will be taken if necessary may itself be sufficient. Indeed, evidence indicates
that monetary policy effectiveness is the driving force behind improved macroeconomic performance,
as measured by the reduction of inflation and output volatility15 (Figure 9). Underlying this increased
effectiveness lies central bank independence and greater transparency which gives monetary
authorities the chance to communicate their monetary policy objectives more effectively.
The ECB's two-pillar monetary policy framework, which takes account of real, monetary and financial
factors, provides conditions under which credibility is attained, allowing the euro area to reap the
benefits just discussed. The explicit goal of maintaining price stability, along with an actual quantitative
definition of stability as an inflation rate below but close to 2%, helps anchor inflationary expectations.
Figure 10 shows how inflationary expectations have been anchored since the creation of the euro area
and the ECB. In spite of the slight rise in expected inflation since the early years of economic and
monetary union, expectations remain anchored around 2%. At the same time, new information
relevant for monetary policy formulation is assessed in Governing Council meetings using the two
pillars - the economic and monetary analysis. The economic analysis focuses on real activity and
financial conditions, factors that influence price developments in the medium term. The monetary
analysis provides a longer-term perspective based on the fact that inflation is ultimately in the long run
a monetary phenomenon. Overall, the strategy does not justify short-term activism and efforts to
"finetune" the economy.
The existence of an explicit goal, in combination with the current framework for monetary
policymaking, has been successful in enabling the ECB to establish credibility during its short history. The
ECB's institutional structure also facilitates transparent policy-making and the communication of policy
decisions to the general public and financial markets. That this communication has been successful is
supported by some evidence suggesting that the ECB's focus on a quantitative definition of price
stability has influenced price and wage setters in the euro area. Although prices tend to move very
sluggishly in the euro area compared to, say, the US, inflationary shocks dissipate at a similar rate to
the US - the extra rigidity in the euro area is offset by the benefits of the effectiveness of monetary
policy in anchoring euro area inflationary expectations16.
So what does the foregoing analysis imply for policy prescriptions now? As inflation expectations
appear to be appropriately anchored, it may be tempting for policy-makers to follow an
accommodative monetary policy, riding the back of increased credibility. However, an accommodative
monetary policy would not be a prudent prescription since the inflation expectations of economic
agents may rise, ending the period of low inflation expectations. Indeed, if inflation expectations
depend not only on current inflation, but also on average inflation in an earlier, higher inflation, regime,
a large and persistent shock, such as a negative energy supply shock may well lead economic agents
to raise their expectations that the monetary authority will shift to a higher inflation regime17.
The credibility that monetary authorities have gained so far must not be jeopardized by loosening the
tolerable inflation range. A credible central bank can help stabilize the economy during this oil shock
without moving to a higher inflation target. Indeed, the credible central bank can take advantage of its
credibility during an oil price shock because it faces less of a trade off between inflation and output
than a less credible central bank. This situation enables the credible central bank to counter the shock
through a smaller tightening of monetary policy than would otherwise be the case because the
dynamics of inflation due to expectations are self-contained18. In the specific case of the ECB,
credibility and well-anchored inflationary expectations have allowed monetary policy to be quite
accommodating despite actual inflation at or above 2% for more than two years. More recently,
however, there have been potential upside risks to inflation stemming from both real economic and
monetary developments. As a consequence, the ECB has acted to preempt any unfolding of these
upside risks by withdrawing monetary accommodation. This circumstance underlies the rising rates in
the euro area during the past year.
A potential role for other economic policies?
So far attention has concentrated on monetary policy responses to supply shocks. Before concluding,
it is useful to make a few remarks on the potential role for other economic policies.
First, an economy's tolerance of negative supply shocks will be enhanced if labour market flexibility is
increased. This fact is something that is widely recognised and, in the EU, it has resulted in the
adoption of various policies designed to reduce rigidities within the framework of the Lisbon
Agreement. In the absence of central bank credibility, a monetary policy response to a negative supply
shock is especially necessary because of the sluggish response of real wages to the shock. Negative
supply side shocks increase marginal costs (either directly in the case of an oil price shock or through
the need to employ more labour to produce the same output in the case of the negative productivity
shock). Inflation in these contexts is the result of a lack of adjustment of real wages. Thus the more
quickly real wages adjust, the more quickly actual output will converge to the new potential output. If
economies were more flexible, then the challenge for monetary policy posed by a negative supply
shock would be much reduced19.
Second, if monetary policy is focused on price stability and anchoring inflationary expectations, the
potential recessionary effects of a negative supply-side shock could be countered through fiscal policy.
If fiscal conditions give governments the flexibility to let automatic stabilisers work following a negative
supply shock, tax revenues will fall and transfers increase, stimulating the economy. Moreover, a tight
monetary policy that aims at countering the inflationary consequences of an adverse supply shock
could be accompanied by a discretionary fiscal expansion, i.e. a reduction in tax rates or an increase
in government spending. The latter policies might further contain the recessionary impact of the shock
by offsetting the negative effect of the oil price rise on private demand. Therefore, if government has
the necessary flexibility, fiscal policy could lessen the stabilization burden of monetary policy.
In the euro area, however, the scope for fiscal policy is, at present, limited because of the failure to
tighten fiscal policy, during previous years when output was above trend. As a result, many countries
have been left with significant fiscal deficits and high debt levels. Even the room for automatic
stabilizers to work, while staying within the rules of the Stability and Growth Pact, is extremely limited.
This situation highlights the need for governments to undertake the fiscal reforms necessary to
generate a fiscal balance or surplus over the economic cycle. Only in this way can fiscal policy be
available as a tool to counter the impact of any future negative supply shocks.
Conclusions
To conclude, the message of this paper is that central banks should not respond to negative supply
shocks by loosening monetary policy. To do so would simply undermine the credibility that many
central banks have worked to acquire and increase the costs of restraining inflation in the future.
Rather central banks can exploit the credibility earned in the past - monetary policy is more effective
with well-anchored expectations and this enables central banks to counter inflationary shocks at less
cost.
At the same time, other policies such as fiscal and, more importantly, structural have a significant role.
We should not, after all, forget the classic lesson of Jan Tinbergen that there need to be just as many
instruments as there are targets. Monetary policy cannot do everything and it is far better that it
remains focused on what it is capable of achieving, namely price stability. In this way, it provides the
conditions necessary to achieve other macroeconomic goals, including economic growth and
employment creation.
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Liikan