When inflation rises because of supply-side problems, it may seem strange for a central bank to respond by raising interest rates. After all, interest rates cannot produce more oil, repair damaged supply chains, increase crop yields, or make factories reopen. If inflation is being caused by a shortage of goods and services, the obvious solution would seem to be fixing the shortage rather than making borrowing more expensive.

However, central banks sometimes raise interest rates during supply-driven inflation because their objective is not necessarily to eliminate the original supply shock. Instead, they are trying to prevent the temporary increase in prices caused by the supply shock from becoming a broader and more persistent inflation problem. The central bank is particularly concerned about what happens after the initial shock: whether inflation expectations increase, whether workers demand higher wages, whether businesses continue raising prices, and whether inflation spreads throughout the economy.

What Is Supply-Driven Inflation?

Supply-driven inflation occurs when the economy experiences an increase in the cost of producing or supplying goods and services, or when the amount of goods and services available falls. This can happen for many reasons. A country might experience a shortage of energy, a disruption to global shipping, a natural disaster, a war, poor agricultural conditions, or a shortage of important raw materials.

The important point is that the initial inflation is not necessarily caused by consumers suddenly spending too much money. Instead, the economy has experienced a reduction in its ability to supply goods or an increase in the cost of producing them.

This creates a problem for central banks because monetary policy is much more effective at influencing demand than directly influencing supply.

Preventing Temporary Inflation From Becoming Persistent

This is one of the main reasons central banks may raise interest rates.

A supply shock can initially cause prices to rise, but there is no guarantee that the inflation will remain limited to the products directly affected by the shock. Higher prices can influence wages, business pricing decisions, consumer behaviour and inflation expectations.

Imagine that inflation suddenly rises from 2% to 6% because of an energy crisis. Workers notice that their cost of living has increased substantially. They may begin demanding higher wages to maintain their purchasing power.

Businesses that pay higher wages then face increased production costs. They may respond by increasing their prices.

Workers then see prices rising again and may demand further wage increases.

This can create a feedback process in which higher prices lead to higher wages, which lead to higher business costs, which lead to higher prices.

The original supply shock may have been temporary, but the inflation it created can become persistent.

A central bank can raise interest rates to reduce the strength of demand and make it more difficult for this process to become entrenched.

Reducing Demand Can Help Balance a Supply Shortage

Another reason interest rates can help is that they influence aggregate demand.

Imagine that a supply shock reduces the economy’s ability to produce goods. Suppose the economy can now produce 90 units of goods, while consumers and businesses want to purchase 100 units.

There is a shortage.

Prices will tend to rise because demand exceeds the amount of goods available.

A higher interest rate can reduce borrowing and spending. Households may reduce spending on houses, cars and other large purchases. Businesses may postpone investment projects because borrowing has become more expensive.

Suppose demand falls from 100 units to 93 units.

The supply problem still exists because the economy can only produce 90 units. However, the gap between demand and supply has become smaller.

This can reduce the pressure on prices.

Therefore, higher interest rates do not necessarily solve the supply shortage itself. Instead, they reduce the amount of demand competing for the limited supply.

The Role of Borrowing and Spending

Interest rates influence the cost of borrowing throughout the economy.

When interest rates are low, households may be more willing to take out mortgages, purchase cars using loans, use credit and make other large purchases. Businesses may also be more willing to borrow money to build factories, purchase equipment or expand their operations.

When interest rates rise, borrowing becomes more expensive.

A household that was considering taking out a large mortgage may decide to borrow less. A business considering a major investment might postpone the project because the expected return is no longer sufficient to justify the higher financing costs.

As spending and investment slow, demand in the economy becomes weaker.

This is important because supply-driven inflation can become particularly problematic when the economy already has strong demand. If supply falls while demand remains extremely strong, prices can rise much more rapidly.

A central bank may therefore raise interest rates to prevent strong demand from amplifying the effects of the supply shock.

 The Labour Market and Wage Pressure

The labour market is another important part of the story.

Suppose a supply shock causes inflation to rise sharply. Workers may seek higher wages because their purchasing power has fallen.

If the economy has very strong demand and businesses are competing aggressively for workers, companies may be willing to provide substantial wage increases.

Higher wages can help workers maintain their purchasing power, but they can also increase business costs.

Businesses may respond by raising prices.

This does not mean that higher wages automatically cause an inflationary spiral. Wage increases can simply reflect workers catching up with previous price increases. However, central banks worry about situations in which wage and price increases begin reinforcing one another.

Higher interest rates can cool the labour market by reducing economic demand. If businesses experience slower sales and investment, they may reduce hiring or become less willing to offer very large wage increases.

Again, the central bank is not fixing the original supply problem. It is attempting to prevent the supply shock from creating a self-reinforcing cycle of wage and price increases.

The Exchange Rate Can Also Matter

Interest rates can influence the value of a country’s currency.

If a central bank keeps interest rates significantly lower than other countries, investors may find assets in that country less attractive. This can put downward pressure on the currency, although exchange rates are affected by many factors and are not determined by interest rates alone.

A weaker currency can make imported goods more expensive.

For a country that imports large amounts of fuel, food, machinery or manufactured products, this can create additional inflationary pressure.

For example, imagine that global energy prices have already increased because of a supply shock. If the domestic currency also weakens significantly, imported energy may become even more expensive in domestic currency terms.

A central bank may therefore consider the exchange-rate effects when deciding how strongly to respond to supply-driven inflation.

Supply-Driven Inflation Creates a Difficult Policy Trade-Off

This is why supply-driven inflation is particularly difficult for central banks.

With demand-driven inflation, the solution is relatively straightforward. If consumers and businesses are spending too much, higher interest rates can reduce demand.

With supply-driven inflation, the central bank is essentially caught between two problems.

If it does too little, inflation may become persistent.

If it does too much, it may unnecessarily weaken the economy.

The central bank therefore has to determine how much of the inflation is temporary, how much is becoming persistent, whether inflation expectations are changing, how strong demand is, and how the labour market is behaving.

Lauren Hua is a private client adviser at Fairmont Equities.

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