There is good reason to believe that temporary surges of inflation, driven by large swings in relative prices, will become more common. For starters, an energy transition is underway, so increases in energy demand may well run up against supply constraints, which are even more likely amid rising geopolitical tensions; the recent attacks by Houthi rebels on ships in the Red Sea may offer a glimpse of what is to come.
Under these circumstances, straightforward inflation targeting might prove inadequate. Central banks should be considering whether, in the face of uneven supply shocks, they should give themselves more time to bring inflation back to target. After all, the standard prescription of aggressive monetary-policy tightening – which works by depressing aggregate demand – will prove less effective in reining in inflation caused by uneven supply-side shocks. And it will carry high costs. Beyond undermining financial stability and employment, excessive tightening hampers relative price adjustment, thereby reducing the efficiency of resource allocation. If monetary conditions remain tight for a prolonged period, investors might be discouraged from pursuing longer-term investments, such as in green technology.
In short, when inflation is driven by supply constraints, monetary tightening alone is not the answer. Fiscal-policy action – and monetary and fiscal coordination – will also be needed. We are not living in the 1970s or the 1990s. How we think about inflation must apply the lessons of past experience (including from the recent past) to current price conditions and, on that basis, attempt to anticipate what the future may hold.
Lucrezia Reichlin, a former director of research at the European Central Bank, is professor of economics at the London Business School.