Persistent Supply Shocks: A Pain in the Neck for Central Banks?

Abstract

Between 2007 and 2008, the Chilean economy experienced multiple cost shocks, ranging from skyrocketing international commodity prices to the cut of natural gas supply from Argentina. These shocks, which were more persistent than expected when they first started, led to an inflation rate that significantly exceeded the target established by the Central Bank. With this in mind, the objective of this paper is to analyze and quantify the implications of the more persistent supply shocks on the main macroeconomic variables, i.e., the inflation rate, the output gap, the interest rate, and the exchange rate. We find that more persistent supply shocks lead to greater inertia (as expected), as well as to greater volatility of these variables. This, in turn, causes the disequilibrium generated by this type of shock to disappear rather slowly. In addition, a greater level of indexation originating in a potential de-anchoring of expectations could intensify the impact of supply shocks’ persistence. Finally, the effects on inflation are nullified if the central bank only considers the inflation rate in its loss function.