Rising oil prices due to turmoil in the Middle East often trigger market concerns about central bank interest rate hikes. However, economist Alexander Salter recently cautioned in an analysis published on TheDailyEconomy.org that when inflation stems from geopolitical conflicts and supply disruptions, monetary policy is inherently ineffective. Aggressive tightening not only fails to resolve energy shortages but may also transform an external supply shock into a domestic demand recession, worsening economic conditions.
Salter pointed out that whether it is the interest rate decisions of the United States, Europe, or the United Kingdom, they cannot produce an extra barrel of oil from the Persian Gulf or reopen blocked trade routes. In the face of supply-driven inflation, the central bank's real role is to prevent financial market panic from spreading to credit markets and avoid an economic downward spiral—rather than attempting to "defeat" a war by suppressing demand.
This analysis has direct implications for investors. If central banks misjudge the situation during a supply shock and aggressively raise rates, markets will face a double blow: bearing the cost pressures from rising energy prices while also coping with job losses and reduced investment due to monetary tightening. Salter warned that the worst outcome of a policy error would be pushing the economy into a deeper recession before war-driven inflationary pressures naturally subside.
Supply shocks and demand shocks are fundamentally different, and the same policy tools cannot be applied universally. Salter's argument begins with the classic macroeconomic framework distinguishing between "demand-driven inflation" and "supply-driven inflation."
When inflation arises from overheated demand—that is, too much money chasing too few goods—central bank intervention is justified. Tightening policies can cool down excessive consumption and investment without causing long-term economic harm.
However, oil shocks triggered by war are fundamentally different. Tightening energy supplies or sudden increases in transportation costs mean the overall economy becomes poorer and less productive. These are real losses that an economy must absorb after an external shock, not illusions that monetary policy can eliminate. Salter argues that attempting to fully offset this reality with monetary tightening may instead produce worse outcomes: layering output declines and rising unemployment on top of already high prices.
Salter acknowledges that the pain caused by war-driven energy price increases is unavoidable—households will pay more at gas stations, and businesses will face higher costs. However, he believes that aggressive central bank tightening could transform this external shock into a collapse in domestic demand, with potentially more severe consequences.
His judgment is specific and direct: for most workers, keeping a job in a 4% inflation environment is far more acceptable than being unemployed in a 2% inflation environment.
Slowing money supply growth and raising interest rate targets do not solve the fundamental supply shortage; they merely redistribute the burden—often shifting it onto workers. In this scenario, raising interest rates essentially trades job losses for a reduction in an inflation figure that the central bank cannot eliminate in the first place, resulting in a net loss.
If central banks cannot "defeat" a supply shock, what should they do? Salter offers a clear functional定位.
During geopolitical crises, the most effective role for monetary authorities lies in stabilizing demand. Specifically, when financial stress indicators signal trouble, central banks can provide liquidity to markets to prevent financial stress from amplifying the shock; they can assure markets that the banking system and capital markets will function normally; and they can conduct routine open market operations to prevent widespread collapses in investment and employment.
Salter emphasizes that the real danger is not the initial rise in energy prices but rather frightened investors, tightening credit conditions, or collapsing market confidence triggering a self-reinforcing economic downturn. The central bank's task is to prevent these "second-order effects," not to confront the "first-order shock" it cannot change.
Salter anticipates质疑 from critics: would tolerating temporarily high inflation cause inflation expectations to become unanchored and damage the central bank's credibility?
His response is that credibility is not built by mechanically reacting to every price increase but by making accurate judgments about the sources of inflation and responding appropriately. If the public understands that the central bank can distinguish between supply shocks and demand shocks, credibility can actually be strengthened.
Salter believes that, provided inflation expectations remain anchored, the optimal strategy is often to "look through" the initial inflationary impulse—that is, tolerate temporarily elevated overall inflation while clearly communicating to markets the external and temporary nature of the shock. He explicitly states that central bank officials should plainly inform the public: price spikes are the result of geopolitical events, beyond the control of monetary policy—the Federal Reserve cannot drill for oil, nor can it end wars.
The worst policy error, Salter concludes, is acting impatiently and hastily: tightening aggressively and deepening an economic downturn before war-driven inflationary pressures have begun to subside on their own, turning avoidable losses into reality. War makes society poorer—a fact that cannot be avoided. The best outcome monetary policy can achieve is to ensure that the cost of economic adjustment is not higher than necessary.