Authored by Alexander Salter via TheDailyEconomy.org,
Every time conflict erupts in the Middle East and oil prices jump, the same anxiety follows: will central banks respond with tighter money?
It’s an understandable fear.Households dislike inflation, and policymakers are tasked with maintaining price stability. But when inflation is driven by geopolitical crises — such aswar in Iranordisruptions to global shipping lanes— the source is not excessive demand. It is a supply shock. And monetary policy is impotent before such disruptions.
When oil supply tightens or transport costs surge, the economy becomes poorer. Energy becomes more expensive to extract and move. No interest rate decision in Washington, Frankfurt, or London can produce more oil from the Persian Gulf or reopen a blocked trade route.
In these moments, central banks face a difficult but crucial choice. They can tighten monetary policy in an attempt to suppress inflation by weakening demand, slowing hiring, curbing investment, and cooling total dollar spending. Or they can allow a temporary period of elevated prices to absorb part of the shock while keeping the broader economy intact.
The instinct to “do something” about supply-side price hikes is powerful. But tightening monetary conditions to combat a supply shock risks compounding the damage. Slower money growth and higher rate targets do not solve theunderlying scarcity. They merelyredistribute the burden— often toward workers.
If energy prices spike because of war, households will pay more at the pump and businesses will face higher costs. That pain is unavoidable. But if central banks respond aggressively by tightening policy, they risk turning an external supply shock into a domestic demand slump.Unemployment rises, investment stalls, and wage growth falters. For the vast majority of workers, having a job amidst 4 percent price growth is preferable to unemployment amidst 2 percent price growth.
There is along traditioninmacroeconomicsof distinguishing between demand-driven and supply-driven inflation. When inflation stems from overheated demand (too much spending chasing too few goods), central banks are right to step in. Tightening policy can ease the frenzy without causing long-term economic damage.
But war-induced oil shocks are different. They make the economy less productive. Attempting to fully offset that reality with tighter monetary policy can produce a worse outcome: lower output and higher unemployment layered on top of higher prices.
The least harmful strategy in such circumstances is often to “look through” the initial inflation impulse — provided inflation expectations remain anchored.
Source: ZeroHedge News
