Economists at the Canadian University of British Columbia analyzed the problem of choosing a strategy for the Central Bank to combat inflation surges during a supply shock.

Under different conditions of supply shock, central bank anti-inflationary actions can be effective in two different strategies, separated by a threshold level of changes in inflation expectations, economists at Canada’s University of British Columbia suggested in a September publication on the topic. The recommended change in strategy is very similar to the actions of the Bank of Russia in August-September 2023: a rapid transition of the strategy from moderate to aggressive, the researchers believe, in such cases may be the most effective tool for central banks to absorb supply shocks.

The problem of choosing the optimal strategy for a central bank to deal with supply shock-induced spikes in inflation, economists Paul Bedri and Amartya Lahiri of the University of British Columbia in Vancouver and Thomas Carter of the Bank of Canada write in an article for NBER, has become especially pressing in the wake of the COVID-19 pandemic. As a result of the pandemic, which itself was a huge shock on the supply side, the superimposition of new supply shocks on each other made the choice between a moderate and an aggressive strategy the main one for any central bank.

Essentially, neo-Keynesian economic theory now gives two opposing answers about the optimal actions of the central bank in such conditions. Almost everything depends on how a particular regulator views inflation expectations – there are two more or less equally accepted approaches to them. The first is the rationality approach of inflation expectations, the second is the so-called adaptive expectations approach. In the first case, the central bank generally believes that its actions should be based entirely on an assessment of the total magnitude of the supply shock as such and the calculation of a strategy taking into account the time for the economy to adapt to a new level (or rather, to new levels – the shock itself has its own dynamics, supply can recover on its own after a shock, and a separate issue was, as in the case of a pandemic, the separation of “true” supply shocks caused by purely economic reasons from “false” ones caused by exogenous, including non-economic, circumstances, for example, disasters, wars, trade embargo, etc.) – and it follows from this that the increase in the key rate should be smooth, including in order to avoid imbalances emerging in the labor market. Accepting the idea of ​​adaptive inflation expectations, on the contrary, requires an assessment of the volume and nature of the necessary actions of the central bank for a rapid return to more anchored inflation expectations. Since expectations are more dynamic than supply, in the second case it is similar to rapid and sharp rate increases.

The problem that the Bank of Russia apparently faced most in the summer of 2023 is that the two models of inflation expectations are equally problematic; the real behavior of expectations contains evidence of both adaptive and rational changes. Bedri, Lahiri and Carter in their work propose the use of one of the new models that explains the dynamics of inflation expectations – the LKT model, which combines both mechanisms of expectation formation in a complex way. Modeling the optimal behavior of the regulator when using it gives an unusual conclusion: in the case of a slight deviation of inflation from the central bank’s inflation target with slow dynamics, moderation in the rate change is necessary (that is, a strategy based on measuring the demand shock); if the dynamics accelerate, a rapid change in the strategy and “ hawkish policy, strong rate growth, as when using the adaptive expectations model.

The level at which a policy “reversal” is rational, the authors believe, can even be determined quantitatively. Let us note that the Bank of Russia made just such a “turn” in August 2023 – the assumptions of Bedri, Lahiri and Carter will de facto be tested experimentally; we note that a number of other regulators took similar actions following the results of the pandemic.

Dmitry Butrin