Inflation Targeting Under a Supply Shock
A central bank with an explicit inflation target of 3 percent, plus or minus 1.5 percentage points, faces a supply shock: a 40 percent rise in an imported energy price feeds through to headline inflation of 7.2 percent, while core inflation is 4.1 percent and the output gap is estimated at minus 1.8 percent. The exchange rate has depreciated 12 percent in three months. The finance ministry publicly argues for cutting the policy rate to support growth, citing the negative output gap. The central bank's communication framework says it 'looks through' temporary supply shocks but responds to second-round effects. The next monetary policy meeting is in three weeks, and the bank's credibility depends on anchoring expectations, which a recent survey shows drifting to 5.5 percent for next year.
1. Should the central bank cut, hold, or raise the policy rate? Justify using the framework's own logic.
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The bank should hold or raise, not cut. The framework says it looks through temporary supply shocks but responds to second-round effects. The evidence of second-round effects is the drift of expectations to 5.5 percent, above the tolerance band, and core inflation at 4.1 percent, above the 3 percent target and near the upper bound of 4.5 percent. The negative output gap and the ministry's growth argument are relevant but do not override the anchoring mandate: cutting into drifting expectations would validate them and raise the credibility cost. A hold with hawkish communication is the minimum; a modest hike is defensible if expectations continue to drift. The ministry's argument conflates the first-round price-level effect with persistent inflation. The tested judgement is applying a stated framework consistently under political pressure rather than reacting to the headline number alone.
2. How should the central bank communicate the decision to the finance ministry and the public?
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Communication should separate the diagnosis from the decision. The bank should acknowledge the supply shock and the negative output gap, showing it is not indifferent to growth, then explain that the tolerance band is being breached by expectations rather than by the one-off price level, and that the framework commits it to act on second-round effects. It should publish the expectation survey and core measures to make the reasoning verifiable. To the ministry, the bank should communicate privately and early, before the public statement, to avoid the appearance of a public split that would itself unanchor expectations. The bank should avoid promising a specific path, preserving data dependence. The tested skill is maintaining central bank independence and credibility while managing a political principal without capitulating or humiliating it.