New Shocks, Old Debates

Key Points

• Food inflation poses a specific challenge for policymakers.
• The European Commission proposes to fund some of the investment effort needed to restore energy security by auctioning unused CO2 emission permits. We are not convinced it’s the right signal to send.
• The “recession” word is back in the open discussions of the Fed members. For now, hawks and doves can agree on a substantial tightening given the signs of overheating. This will change.

After a short reprieve wheat prices have started spiking again. Food inflation poses a specific challenge for policymakers: it is both socially regressive (it specifically affects those at the bottom of the income distribution) and highly visible (it’s a high frequency consumption). Food inflation thus fosters massive social demand for government action. Symmetrically, given its high visibility for households, protracted increases in food prices can push inflation expectations up, making central banks less than keen on easing the funding of such a fiscal mitigation. This is a variation on a theme which we have been exploring for some weeks now: the disappearance of policy space. Some of the current discussions eerily echo the debates which were rife at the dawn of economic science.

Yet, for now it’s the pressure from energy prices which is the focus of governments’ attention, and preparations continue to deal with the possibility of an embargo on Russian energy. Upon unveiling its “Repower EU” plan the Commission has come up with an intriguing solution to fund the investment effort: sell some of the unused carbon emission allowance currently held in the Market Stability Reserve. We are not convinced. Corporates and financial institutions need a clear price signal to be able to accurately allocate capital towards decarbonization. Creating the impression that emission permits would be seen by public authorities more as a source of funding than as a way to create the right incentives for cleaner production could distort this price signal.

The coexistence of demand-led and supply-led inflation is a major difficulty for the Fed. The central bank ultimately must choose between two policy options: “run demand to the ground” – in clear trigger a significant recession - so that the part of inflation which is sensitive to cyclical conditions declines enough to offset the continuing positive contribution from the supply-side. Or allow some overshooting of headline inflation relative to its target once the demand-side component has been tamed. Unity at the FOMC may be temporary: as long as the signs of overheating are obvious, hawks and doves can easily agree on a substantial tightening. Disagreements are however likely to reappear when the positive output gap disappears.