As the Federal Reserve considers how to respond to the latest inflationary spike, a former central banker has warned that the traditional monetary policy playbook doesn’t apply.
In a Substack post last week, former Philadelphia Fed President Patrick Harker argued that the term “supply shock” is a mischaracterization of what’s really been going on in recent years.
That includes Moscow cutting off natural gas supplies to Europe in retaliation for sanctions the West imposed after Russia invaded Ukraine. Energy prices soared as European countries scrambled to find alternative gas supplies.
“A shock is surprise. A shock is the kind of thing you absorb, smooth out, and move past,” Harker wrote. “What Russia did to Europe’s gas supply was none of those. It was a deliberate act, executed for political purposes, using a chokepoint Russia controlled.”
The gambit worked, and Russian President Vladimir Putin learned what his strategic leverage can do as he played his card again.
As a result, the term shock doesn’t fit, Harker added. “I want to argue for a different word. Supply coercion.”
He listed other examples, such as Houthi rebels attacking ships in Bab El-Mandeb, the strait that connects the Red Sea with the Indian Ocean, cutting off a vital shipping lane between Europe and Asia.
Supply chokepoints don’t have to geographic. China leverages its dominance over rare earths, while Democratic Republic of Congo, Indonesia and Chile are also major sources of vital minerals.
The latest crisis that fits into his framework is Iran’s closure of the Strait of Hormuz that has stopped the flow of one-fifth of the world’s oil supplies.
The Fed doesn’t have its own military
Looking back on the series of disruptions, Harker said each one looked like a one-off, unrelated event at the time. But the pattern only became visible when the events were stacked together.
“I’m not saying we missed it. I’m saying the framework we were trained in, supply shocks as random draws from a stable distribution, was the wrong framework for what was actually happening,” he added. “The shocks weren’t random. They were strategic. The actors generating them were learning.”
The problem for central bankers is that monetary policy, which targets demand, can do little about supply coercion, Harker explained.
When a a strategic actor deliberately limits supply, the resulting inflation is a national security problem and not a problem for the Fed.
“The Fed isn’t a logistics company. It isn’t a defense department,” he said.
To be sure, the U.S. has disrupted supplies too, namely in the form of President Donald Trump’s tariffs, according to Harker.
But again, Fed rates have limited effect on tariff-driven inflation. Policymakers are now in bind, caught between coercion from abroad and coercion generated at home.
“The word ‘shock’ assumes the world resets,” he warned. “The world has stopped resetting.”
‘One Transitory Shock After Another’
But shock is precisely how current Fed officials are describing their dilemma of stubbornly high inflation, making them less inclined to remain on course for future rate cuts by “looking through” short-term price spikes.
“More than five years of above-target inflation has reduced my patience for ‘looking through’ another supply shock,” Boston Fed President Susan Collins said Wednesday. “And while it is not my most likely outlook, I could envision a scenario in which some policy tightening is needed to ensure that inflation returns durably to 2% in a timely manner.”
The comments echoed what Fed Governor Chris Waller said last month, when he delivered a speech titled “One Transitory Shock After Another.”
He said he learned from the Fed’s prior mistake to treat the 2021-2022 inflation spike as transitory and will be more cautious during a series of shocks.
“While intellectually it makes sense to look through each shock, with a sequence of shocks, policymakers need to be more vigilant,” Waller noted. “This is because if the shocks hit one after another, they will keep inflation elevated for quite some time. The standard ‘look through’ can become problematic if businesses and households start to believe inflation is persistently high and it affects their price- and wage-setting behavior.”
