What is inflation and what is price shock?
This question sounds theoretical and perhaps heavy, but in fact it is of enormous importance these days and can decide a lot about the continuation of the global interest rate policy.
A price shock is when the prices of products or services rise one-time, or suddenly, either proactively (such as products and services that are under government supervision), or as a result of an external shock (natural disasters that destroyed agricultural crops or shut down oil fields, for example) or whether Due to the structure of the market (such as the cartelistic oil market, which is subject to announcements of the opinion of the OPEC cartel and Russia and can cause sharp price changes, as we witnessed only recently).
Price shocks will not necessarily translate into inflation, which is a continuous price increase.
This depends on the question of whether these are price blows from the supply side or the demand side, as well as the economic business cycles and the question of whether we are in a period of strong growth, or a recession.
When it comes to a price blow from the supply side, the supply tends to decrease (sometimes to the point of a shortage) and therefore prices will rise and the disposable income from all sources of households in favor of other products and services will decrease – which will lead to a decrease in demand for them and a decrease in their price (for any given quantity). It is possible that the drop in the prices of the other products will be offset and may even be stronger than the original price increase. The less good the economic situation and the household income accordingly – the greater the chance of such a scenario.
When it comes to a price blow from the demand side – the story is different. For example, in the case of pent-up demand – which erupts. During the Corona period, many households preferred, or could not, to purchase a long list of sustainable products, replace furniture, electrical appliances, refrigerators, washing machines, etc. With the end of the foreclosures, everyone rushed to execute purchases that they had reluctantly postponed for a long time. Since the supply was slow to adjust itself, the prices of many products and services jumped. This did not come at the expense of other products and services, which also went up. Such an event, unlike the previous one, can also trigger a process of continuous price increase, especially during periods of relatively high growth. Indeed we are witnessing such a continuous increase in the last year.
And where does it meet interest?
Interest rates rise in order to prevent, or mitigate, a continuous increase in prices, as it has a tendency to slow down and if this happens – household incomes will be eroded over time and it will be more difficult to fatten.
However, to the extent that it is a price blow, in particular on the supply side, the interest rate will not necessarily rise, since as mentioned, its final result can be an overall drop in prices.
In June of last year, the Federal Reserve Bank of Richmond, USA addressed this. In a working paper published by its researchers, it is stated that inflation is determined by the interaction between supply shocks, or demand, which affect various components of the consumption basket, and the monetary policy being pursued. The researchers discovered a strong connection between price shocks and continuous price increases.
For example, the deficit inflation that remained in the United States from 2012 to 2019 (1.4%+ on an annual average, compared to an inflation target of 2%) was due, in the first half of the period, to shocks in the health care markets and gasoline and other energy products, while from 2016 it was the interest rate that rose and became dominant More.
In another case, regarding the high inflation that broke out with the end of the corona virus, the researchers discovered that although the expansionary monetary policy (zero interest rates) that was adopted during it was an important factor in the outbreak, but sectoral shocks (especially in the vehicle markets) were more important and are in fact the main “culprits” for the inflation outbreak in the past few months May to November 2021.
In the bottom line, the researchers state that:
A. Inflation is not necessarily and not always a phenomenon attributed only to price shocks, but also to the monetary policy that preceded them, or followed them.
B. The more reliable a policy that will lead to more stable inflation, because then the price fluctuations that will be left are the ones that will be attributed to the price shocks.
In view of these important distinctions, it is important that the distinction between price shocks and inflationary processes is also emphasized in our media discourse, and also, which part of inflation is caused by price shocks and which part is caused by monetary policy.
Ronan Menachem is Chief Markets Economist at Bank Mizrahi Tefahot