Supply-Shock Inflation in a Small Open Economy with Indexed Wages
Kestrel is a small open economy with an inflation target of 3% with a tolerance band of plus or minus 1 percentage point, a floating currency and gross public debt of 78% of GDP. Headline CPI inflation is 7.2%, core is 5.9%, and the central bank's survey shows one-year-ahead expectations at 5.4%, up from 3.1% a year earlier. Sixty percent of private-sector wage contracts are indexed to past CPI with a one-quarter lag. The currency has depreciated 14% in six months after a terms-of-trade shock: energy import prices are up 45% and non-energy import prices 9%. The output gap is estimated at -1.8%, unemployment is 6.4% (the NAIRU is 5.5%), and the policy rate is 4.25% while the fiscal deficit is 5.6% of GDP with no consolidation planned. The government has announced a 4% public-sector wage increase and an energy subsidy costing 1.4% of GDP. The next policy meeting is in three weeks.
1. Decompose the inflation outcome and decide whether the central bank should tighten despite the negative output gap. Provide a numerical policy-rate recommendation.
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Decomposition. Headline 7.2% is dominated by the energy shock (45% import price increase), plausibly 2.5-3.0 points of the total. Depreciation pass-through of 14% at a 0.2-0.3 coefficient adds roughly 1.0-1.5 points to core. Core at 5.9% is therefore mostly imported and second-round, not demand-driven: the output gap of -1.8% and unemployment 0.9 points above NAIRU indicate slack, which if anything is subtracting from inflation.
Why tightening is still warranted. The target is being missed by 4.2 points, expectations are 5.4%, and 60% of wages are indexed to past CPI. That combination is the transmission mechanism for a wage-price spiral: today's CPI becomes next quarter's wages, which becomes next year's prices. The real policy rate is 4.25 - 5.4 = -1.15%, clearly negative and thus accommodative during an inflation shock.
Recommendation. A simple reaction function with r* = 1%, target 3% and equal weights gives i ≈ 1 + 5.9 + 0.5(2.9) + 0.5(-1.8) = 7.45%, or 3.1% in real terms. That is likely too contractionary given the gap, so a calibrated path is better than a level jump: raise 50 bp now to 4.75%, signal another 50-75 bp over the following two meetings, and state explicitly that the path responds to core and expectations rather than to the energy price level. Forgoing a response until the output gap closes would allow real rates to stay negative and expectations to drift further.
2. Assess the fiscal stance and its interaction with monetary policy. What changes would you recommend?
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Stance. A deficit of 5.6% of GDP with a negative output gap is not automatically imprudent, but the composition is pro-cyclical: the 4% public-wage increase and the 1.4%-of-GDP energy subsidy add demand and blunt the price signal exactly when policy needs to reduce it. Debt at 78% of GDP is exposed to the rate path: each 100 bp rise in average funding cost adds roughly 0.8% of GDP to interest over time on a 78% stock, crowding out other spending.
Interaction. Fiscal expansion and monetary tightening pull against each other. The subsidy suppresses headline CPI directly, which makes the inflation target easier to hit in the short run while raising core via demand, and it weakens the central bank's ability to read underlying pressure. A central bank tightening while the treasury subsidises energy faces a fiscal-dominance problem: the more it raises rates, the more it pays on debt and the more the subsidy costs.
Recommendations. (1) Replace the universal energy subsidy with a targeted lump-sum transfer to the bottom two income quintiles, cutting the cost to about 0.5% of GDP and restoring the price signal. (2) Phase the public-sector wage rise to 2% and tie the remainder to a productivity review. (3) Announce a consolidation path of 1.5-2.0% of GDP over two years, weighted toward the recovery, so the deficit falls without deepening the current slack. (4) Publish a debt-sustainability annex showing the interest-rate and growth sensitivities, so monetary and fiscal choices are visibly coordinated rather than offsetting.
3. What are the main risks to credibility, and how should the central bank communicate at the next meeting?
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Risks. First, the band: headline at 7.2% is far outside the tolerance range, and repeated extensions of the horizon would signal that the target is flexible in practice rather than in design. Second, the survey: one-year expectations at 5.4% are above the band, and indexed contracts convert them into wages mechanically. Third, fiscal dominance: if the treasury does not adjust, the market may read any rate rise as temporary and price higher inflation or a risk premium. Fourth, communication risk in both directions - sounding relaxed about 5.9% core would invite further drift, while promising to return to 3% within a year would be incredible and would damage credibility when missed.
Communication. (1) Present a decomposition table separating energy, imported non-energy, wages and demand, so the public sees why the bank is responding to core and expectations, not to the energy level. (2) State a conditional path - the 50 bp now plus a data-dependent further 50-75 bp, with explicit triggers on core, unit labour costs and expectations. (3) Publish an 18-24 month horizon for returning to target, acknowledging the trade-off with the output gap, rather than a short deadline that will not be met. (4) Ask the government publicly, but neutrally, to align fiscal policy with the target. (5) Describe the tolerance band and the escape clause triggers in advance, so any use of flexibility is rules-based rather than discretionary.