Federal Reserve governor Chris Waller on Friday cast serious doubt on the textbook look-through strategy to handle the Iran War-induced inflationary pressure — or what we fashionably called the “War? Sh~” strategy. And he is not the only central banker who has expressed reservations.
In normal times, central banks tend to ignore oil price surges. It is because oil price fluctuations—and the war that pushes them higher—tend to be short-lived. Given the long and variable lag of monetary policy impact, it is likely that when the rate hikes finally affect the real economy, the inflation problem has already gone away. War? Sh~! We don’t need to talk too much about it.
But Waller on Friday deployed a fancy term—Bayesian Learning—to illustrate his warning against ignoring the Iran War inflation episode. The concept is about how people will update their prediction given new information.
In this case, the observed inflation rate, which has been pushed above the 2% target by successive supply shocks for the last five years, is the information in question. The public so far believes that inflation will ultimately return to the target. But when the evidence keeps challenging their core belief, they will ultimately update their belief in accordance with observations.
“There must be some reason the inflation rate can’t be returned to 2% and it is foolish to trust that it will.” This updated belief will introduce higher inflation expectations and the unanchored expectation will lead to a vicious cycle, pushing the inflation even higher.
In fact, Waller is not alone in worrying about this situation. As early as September last year, Megan Greene, an external member of the Bank of England’s Monetary Policy Committee, gave a speech on why, as supply shocks become more frequent and severe, look through may no longer be the optimal strategy.
In a recent Odd Lots episode, Greene applied her argument to the Iran War-inflicted economy.
“[The Bank of England have] done a lot of research showing that households and businesses are possibly more attentive to inflation once inflation comes within a certain band… in the UK we think that if inflation is somewhere between 3 and 3.5%…So, if you then have another negative supply shock and inflation go up, people will be much more sensitive to that.”
This is a different angle on the same inflation expectation de-anchoring problem. People are getting more attentive to further price changes when the inflation rate is high, and they are more likely to revise their expectations.
The crux is that the Iran War is at least the fourth major supply shock since 2020 (Covid pandemic, Ukraine War and US tariffs) and the global economy was hit by consecutive rounds of cost push over the last five years. Can the central banks confidently believe that the public will not have second thoughts on whether the inflation targeting system is credible? And for how much longer? This is the defining challenge of monetary policy now.
