Financial institutions

The pandemic's disruption of global supply chains and the spike in natural gas prices following Russia’s invasion of Ukraine were significant drivers of surging inflation. Traditional inflation models often ignore such supply-side shocks, even though they can have a significant and persistent impact on core inflation in the euro area (as measured by rates of change in the Harmonised Index of Consumer Prices excluding the energy and food components).

The 2021-22 surprise inflation surge had a major impact on households in the euro area. It reduced the real incomes and net wealth of most households as there was no immediate increase in nominal wages and pensions, nominal house prices and the nominal value of bonds, deposits, cash and debt following the rise in the price level. This influenced households’ present and future consumption and therefore their welfare.

When inflationary pressures started intensifying in 2022, the world’s major central banks faced a dilemma. They could rapidly tighten monetary policy at the risk of fuelling financial distress after years of ultra-low interest rates and balance sheet expansion. Or they could take a more gradual approach to fighting inflation that would protect the financial system, but risk high inflation becoming entrenched. While severe financial instability may be an unlikely event (or “tail risk”), it can have devastating macroeconomic consequences.

This column presents evidence on the role that US monetary policy plays in how fiscal spending affects the economy. A dovish Federal Open Market Committee (FOMC) delays policy rate increases, while a hawkish FOMC tightens monetary policy more promptly, following increased fiscal spending. We show that the dovish response supports fiscal expansions. In contrast, the hawkish response results in a GDP decline but effectively controls inflation expectations.