Misdiagnosis? The risk of an economic policy mistake is higher than ever

The methods by which policymakers have responded to commodity shocks have changed over time. The risk of course is that authorities are always fighting the last war with the same tactics, when in fact the game has changed.

The experience of oil supply disruptions and resulting high inflation of the 1970’s led authorities to treat commodity price shocks as a function of exogenous supply shocks. The medicine (high interest rates) tasted bad, and focused on the second order impacts (higher inflation).

However, since the start of the 21st Century the literature and the conventional wisdom has focused on commodity price shocks as largely a being a demand side issue. The emergence of China and many emerging economies onto the world stage led to dramatic growth in demand for commodities.

Policymakers are aware that their action also influence commodity demand and by extension prices. If commodity prices are taken as an indicator of demand then they may misdiagnose the cause of price weakness / strength as a deficiency / surplus of monetary stimulus.

And so there is a risk that a monetary authority may misdiagnose a commodity price swing as being driven by an external supply shock when it is, in fact, driven by an endogenous global demand shock, and vice versa.

A new paper from the Bank of International Settlements and the European Central Bank highlights the challenge that monetary authorities face, but also the risk that they may make it worse:

First, it is important to distinguish between global demand and supply shocks when responding to commodity prices. If it is possible to accurately diagnose the source of a shock, our model finds that the best response to demand shocks is to lean against them fully (a result consistent with a standard New Keynesian closed economy model). The best response to commodity supply shocks (i.e., a decrease in commodity prices) is to look through them.

Second, the conventional wisdom of looking through the first round effects of commodity price swings is not always optimal. In our model, this result arises because our model breaks the “divine coincidence” between inflation and output gap stabilization, which is a standard feature of DSGE models with exogenous commodity prices. The breaking of the divine coincidence comes, in part, from the assumption of a monopolistically competitive commodity exporter, and in part from the imperfect information environment.

Third, misdiagnosis risk matters. In the case where the monetary
authority misinterprets supply-driven increases in commodity prices
as demand driven, the contraction in both output and core inflation is larger than in the case of an accurate diagnosis. This indicates another reason for the breakdown of the divine coincidence in this model (even if the dominant exporter acts as a price taker). This result underscores the potential benefits of trying to correctly diagnose the sources of commodity price swings when setting monetary policy. For example, a monetary authority that misdiagnoses global demand shocks as external supply shocks amplifies cyclical fluctuations (including commodity prices) and, as a result, destabilizes the economy.

The lesson from previous crisis is that it is not necessarily the ‘event’ that created the most damage, but the mistakes by policymakers later that compounded the damage

The global economy is currently dealing with a simultaneous demand and supply side shock that is reverberating across the globe in waves. The potential for miscalculation is arguably higher than it has ever been.

Related article: What I learned from “Principles for Navigating Big Debt Crisis” by Ray Dalio

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