How to Avoid a Supply Shock Inflation Bias

The Federal Reserve has found another inflation spike it would rather not fight. The Iran war has pushed up energy prices, which has helped lift headline PCE inflation to 3.5 percent. Policymakers’ argument is that this is the rare inflation burst that really is transitory. It’s not too much nominal spending pushing up prices, but a one-time rise in the price level as expensive energy squeezes the economy’s capacity to produce.

In theory, this is defensible. The Fed can tighten monetary policy, slow total economy-wide spending, and offset some of the price pressure from higher energy costs. But it cannot conjure up more oil. Provided inflation expectations remain anchored, monetary policymakers have a reasonable case for looking past a temporary energy-price spike rather than squeezing the whole economy to counteract it.

Jerome Powell recently stated the standard case for keeping calm. “Energy shocks tend to come and go quickly,” he said, and “the tendency is to look through any type of supply shock.” A strict 2 percent inflation target during an oil shock would require suppressing nominal spending to offset a jump in energy’s price. The argument is that the Fed would be compounding the output fall: adding a demand squeeze to a supply squeeze, and so risking recession to prove its anti-inflation credentials.

This is the strongest case for advocating a nominal GDP target, or something close to it. Nominal spending equals prices times real output. If an adverse supply shock pushes real output below trend, targeting a stable nominal spending path may mean inflation drifts temporarily higher. That is not “letting inflation rip.” It is refusing to make monetary policy amplify the output reduction of a real shock.

The problem, however, is symmetry. If central bankers commit to look through negative supply shocks, they should also look through positive ones. Otherwise “flexible” inflation targeting becomes biased towards above-target inflation.

That is, if oil prices fall, productivity accelerates, or new AI technology makes firms more efficient, real output potential can rise faster than expected. Under the same “look-through” logic, inflation should then run lower, allowing consumers to reap the benefits of productivity through slower price growth.

Sadly, that is not how policymakers usually think about it. Nonfarm business productivity rose 2.2 percent in 2025, a much faster rate than almost the whole of the 2010s. Oil prices fell significantly last year too. Scott Sumner asks the obvious question: if policymakers really “look through” supply shocks that they have no control over, why did almost nobody call for inflation to run below target ? On the same logic used for oil price spikes, he wrote, it was “appropriate for inflation to run below 2% during 2025.”

The same asymmetry is also shaping the AI debate. Fed chair nominee Kevin Warsh has presented AI as a major positive supply shock, calling it “the most disruptive moment in modern economic history” and saying he was confident it would improve output. The White House agrees. Kevin Hassett says AI-induced productivity puts “downward pressure on inflation.” But both imply that this gives room for the Fed to loosen monetary policy, rather than the Fed “looking through” these developments over which it also has no control.

They may be right about AI’s growth dividend. But if stronger-than-expected productivity growth is a positive supply shock, the first-order lesson of the Fed’s Iran war stance is not that it gets “room” to ease and offset any disinflation. It is that inflation should be allowed to fall, provided nominal spending stays on track. In fact, when inflation is already above target, treating hoped-for productivity gains as permission to loosen monetary policy banks disinflation before it even arrives.

My worry is that there’s an obvious asymmetry developing here. Negative supply shocks? Look through the above-target inflation. Positive supply shocks? Ease policy to prevent below-target inflation. Heads, inflation overshoots. Tails, we still don’t go below target.

If this is how the Fed uses its discretion, it is instituting a clear inflation bias. The FOMC’s own framework affirms that long-run inflation is primarily determined by monetary policy and reaffirms a 2 percent PCE target. That does not require the Fed to react to every oil-price move. It does surely require symmetry for both signs on a supply shock.

The Fed has already erred in an inflationary direction recently. From 2021 onwards, it let talk of negative supply shocks obscure the more important fact that money was too loose and nominal spending then exploded. The public is still paying for this conceptual error through a permanently higher price level. A central bank that now tolerates overshoots from bad shocks while preventing undershoots from good shocks is not practicing flexible inflation targeting. It is building in yet higher inflation over time.

What can be done to keep inflation on target? A monetary policy rule, as Cato’s Handbook on Affordability suggests. Congress should bind the Fed to objective, transparent monetary rules and require public justification for any deviations. If we were to formalize something like a nominal GDP target, the Fed would then be bound to the look-through logic in both directions.