Home / Opinion / Columns /  The return of the supply side challenge

There is little that can match the ability of a crisis to focus minds. The latest edition of the annual central banking shindig at Jackson Hole, a small mountain resort in Wyoming state in the US, is a case in point.

Many of the recent meetings, hosted every August by the Kansas City Fed, have been about conceptual issues. This year was all about the immediate challenges faced by monetary policymakers, and unsurprisingly so. The sharp increase in inflation across most—but not all—major economies ensured that attention was focused on the urgent task of taming the inflation dragon. One of the papers presented at the conference had a succinct first sentence: “Inflation is back." Central banks have thus been forced to focus on their dharma above all.

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The hawkish message from the central bankers at Jackson Hole naturally captured the most global mind space, especially in financial markets. However, there was another message from the conference, though an implicit one, that also deserves attention, since it will have profound implications for how central bankers think about their jobs. It can be called the return of the supply side.

Over the past couple of decades, central bankers, especially in advanced economies, have broadly believed that their main task was to manage aggregate demand in the economy. The supply side would smoothly adapt to changes in aggregate demand, especially since the rise of China in effect expanded the supply of labour as well as productive capacity on a global scale. Votaries of modern monetary theory even argued that slack—or excess capacity—was a permanent feature of a modern economy.

Monetary policy could then look past temporary supply disruptions, since steady inflation expectations as well as a responsive supply side would not lead to demands for higher wages or encourage firms to increase prices in competitive markets (remember the “transient inflation" debate?). The moderation of inflationary pressures also meant that it was safe for a government to run an economy hot for some time, since a flatter Phillips Curve would ensure that loose macro policy did not lead to the sort of inflation that the world had to battle in the 1970s. And in case inflation did climb at some point of time, the output that would need to be sacrificed to get it down to comfortable levels would be minimal.

Many of these assumptions have been profoundly challenged in the past two years, thanks to supply chain disruptions, rising energy prices and the risk of food shortages. The supply side has been rigid rather than flexible. And the situation may persist because of geopolitical tensions as well as the new tide of protectionism. Against this backdrop, here is a sample of what some of the heavyweights said at Jackson Hole.

Jerome Powell, chairman of the US Federal Reserve: “Current high inflation in the US is the product of strong demand and constrained supply."

Gita Gopinath, first deputy managing director of the International Monetary Fund: “Better models of aggregate supply—including those that take more account of capacity constraints at the sectoral level—are… needed."

Augustin Carstens, general manager of the Bank of International Settlements: “We are used to viewing the economy mainly through the lens of aggregate demand, with supply assumed to adjust smoothly in the background… We cannot take aggregate supply for granted."

Isabel Schnabel, member of the executive board of the European Central Bank: “The breakup of the Soviet Union and global economic liberalization from the 1980s onwards led to about half of today’s world population being integrated into the global economy. Labour supply became so abundant, and production capacity so large, that even periods of strong demand rarely succeeded in putting persistent upward pressure on prices and wages."

This revival of interest among global policy-makers in supply side shocks or disruptions leads to several important questions. First, is the world headed into a new era of rigid supplies? The rise of protectionist sentiment across the world means that governments want to produce key goods inside their borders; but it is worth asking whether the quest for resilience in each individual country will lead to a loss of resilience for the world economy as a whole.

Second, the disruptions since early 2020 because of covid restrictions and the war in Ukraine will eventually ease. A more serious set of supply shocks are on the horizon as the world learns to adapt to the harsh reality of climate change. This involves both the disruptions from extreme climate events as well as the transition to new forms of energy, mobility and living. Policymakers have begun to bring climate concerns into their models—both mental as well as statistical—but the actual conduct of macro policy will involve a steep learning curve.

Third, while the flip side of aggregate demand is aggregate supply, recent months have shown that the actual micro structure of the economy is as important as the aggregate situation. The best example of this is the automobile industry. The shortage of one key input—semiconductors—has upset production schedules of car companies across the world. The smooth flow of intermediate goods through complex supply chains can be hindered if even one link in that chain breaks. However, hoping to locate an entire supply chain in one place goes against the logic of modern manufacturing.

Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.

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