Energy Shock Puts Bank of England on High Alert for Persistent Inflation

Alan Taylor, of the Bank of England, recently gave a speech at NIESR about the ongoing energy shock and its impact on inflation. The world economy is facing various challenges, including geopolitical uncertainty, shifts in global trade and production, and changes in financial conditions.

Taylor focused on how inflationary energy shocks pass through the economy, their persistence, and the role of expectations in this process. He emphasized that policymakers often rely on imperfect signposts to navigate these challenges.

The Bank of England has identified three types of effects when it comes to energy price shocks: direct, indirect, and second-round effects. Direct effects refer to the mechanical impact of higher energy prices on headline CPI, while indirect effects occur when higher energy prices raise production costs for other goods and services.

The more difficult issue is understanding second-round effects, which describe the behavioral dynamics that can follow an initially temporary rise in inflation and make it more persistent. These dynamics are driven by private decisions without policy intervention, such as workers seeking higher wages to recover lost real income or firms raising prices due to expected changes in their environment.

Taylor noted that monetary policy cannot 'look through' short-lived relative-price shocks but can prevent a shock from propagating into an ongoing inflation process. He highlighted the importance of understanding second-round effects and how much policymakers should lean against this risk given uncertainty about its magnitude and trade-offs between stabilizing inflation and real economic activity.