Monetary policy trade-offs amid global supply chain disruptions
What this paper finds — and why it matters
This paper employs a proxy structural VAR model to examine the effects of global supply chain (GSC) shocks on U.S. macroeconomic variables and the Federal Reserve’s historical response, and evaluates two counterfactual monetary policy rules using the COVID-19 episode. Large fiscal stimulus amplifies inflation while cushioning the output downturn from GSC shocks. Historically, the Fed adopted a loose stance, looking through price surges from supply chain disruptions. The first counterfactual—which stabilizes inflation—entails less accommodation and yields a more favorable inflation-output trade-off, reflecting greater price flexibility and limited output losses. The second counterfactual—which minimizes a dual-mandate loss function—calls for greater initial easing; under inflation targeting (IT) this involves moderate accommodation, while under average inflation targeting (AIT) the looser initial policy generates more persistent inflation and ultimately requires a contractionary response, worsening the trade-off.
Summary based on a working paper version, AI-assisted and human-reviewed. See the linked published article for the authoritative version.
Q1. What is the empirical strategy?
The paper estimates a proxy structural VAR model that identifies GSC shocks using the news-based Supply Bottleneck Index (SBI) of Burriel et al. (2024) as a proxy, then evaluates the Fed’s historical response to those shocks and two counterfactual policy rules that substitute for the historical stance. The proxy SVAR approach identifies the GSC shock’s impulse response function and then traces the macroeconomic dynamics that would have obtained under alternative policy rules, holding the non-policy shocks at their historical values. The SBI captures sudden decreases in supply chain functioning from natural disasters, geopolitical events, strikes, and pandemics.
Q2. What is the role of fiscal stimulus in amplifying GSC shock effects?
Large fiscal stimulus—such as the U.S. transfers and spending during COVID-19—amplifies the inflationary impact of GSC shocks while cushioning the output downturn; the interaction between supply disruptions and fiscal expansion is thus an important determinant of the inflation-output dynamics. Without the large fiscal stimulus, GSC shocks would generate the standard supply-shock trade-off with less amplified inflation. With stimulus, the combination of higher aggregate demand (from fiscal transfers) and reduced aggregate supply (from GSC disruptions) creates a strongly inflationary environment.
Q3. What does the first counterfactual (inflation-stabilizing policy) show?
The counterfactual that stabilizes inflation requires less monetary accommodation than the historical stance and yields a more favorable inflation-output trade-off, suggesting that the Fed’s historical ’look-through’ approach was suboptimal given the interaction with fiscal stimulus. The intuition is that earlier and firmer monetary tightening in response to GSC-driven inflation would have reduced inflation expectations pass-through and prevented a larger buildup of price pressures, while the output cost of that tighter stance was limited by the greater price flexibility the model identifies in this environment.
Q4. What is the comparison between IT and AIT in the second counterfactual?
The second counterfactual calls for greater initial easing than the historical stance; under inflation targeting (IT) this involves moderate accommodation, while average inflation targeting (AIT) implies an even looser initial policy that generates more persistent inflation and ultimately requires a contractionary response, worsening the inflation-output trade-off relative to IT. The AIT result reflects the design of that framework: making up for periods of below-target inflation with above-target periods creates a commitment to easy policy even when supply-side inflationary pressures are elevated, producing a worse outcome when supply shocks drive inflation above target.
Key concepts
proxy structural VAR : a structural VAR identified using an external instrument (the proxy variable) that is correlated with the structural shock of interest but uncorrelated with other shocks; used here to identify GSC shocks using the Supply Bottleneck Index. global supply chain (GSC) shock : a sudden decrease in the supply provision or functioning of supply chains stemming from adverse events (natural disasters, pandemics, geopolitical events); identified in this paper as acting like supply shocks, lowering output and raising prices. average inflation targeting (AIT) : a monetary policy framework in which the central bank targets the average rate of inflation over time, implying accommodation of below-target periods with above-target periods; shown here to imply looser initial policy and more persistent inflation in response to supply shocks, worsening the trade-off relative to standard IT.