Working Paper Series no. 1054. Central banks typically rely on the following heuristic: Look through transitory supply shocks to stabilize the output gap, but pivot toward inflation stabilization when supply shocks become persistent. Yet standard macroeconomic models provide little support for this heuristic. They justify it for markup shocks—a particular type of supply disturbance—but imply that, for the most common supply shocks, such as productivity, labor supply, or energy prices, stabilizing the output gap remains close to optimal even when these shocks are persistent. What, then, rationalizes a hawkish response to persistent supply shocks? This paper shows that, contrary to conventional wisdom, the risk that inflation expectations de-anchor is not sufficient. Even when expectations are backward-looking, output-gap stabilization remains close to optimal. Instead, real wage rigidity emerges as the key mechanism. When real wages are sufficiently rigid, stabilizing the output gap becomes substantially more costly, and optimal policy shifts toward inflation stabilization in response to persistent supply shocks, regardless of whether expectations can de-anchor. These findings suggest that monitoring real wage rigidity may be at least as important as monitoring inflation expectations when assessing the need for a hawkish policy pivot.
Figure: Central Bank Loss under Different Assumptions
Non-Technical Summary
In the face of supply shocks, central banks typically rely on the following heuristic. If the shock is transitory, policymakers should react moderately and prioritize output-gap stabilization. If it is persistent, however, policy should place greater weight on inflation stabilization because of concerns that inflation expectations may de-anchor. This heuristic structured much of the debate on the monetary policy response to the inflation surge of 2021-2023. The recent sharp increase in global energy prices following the blockade of the Strait of Hormuz has brought this heuristic back to the forefront of monetary policy debates.
Yet standard monetary models provide little support for the idea that monetary policy should tilt toward stabilizing inflation when supply shocks are persistent. For the main types of supply shocks that central banks face in practice—productivity shocks such as supply chain disruptions, labor supply shocks such as changes in participation and sectoral reallocation, oil/gas price shocks and other relative-price shocks—standard models find that stabilizing the output gap (the deviation of output from its efficient level) is very close to optimal, even when these shocks are persistent. This is illustrated on the left panel of the figure: under rational expectations, dovish policies that are close to stabilizing the output gap generate a much lower loss than hawkish policies that are close to stabilize inflation.
Does this mean that central banks' supply shock heuristic is wrong, or that standard models miss important aspects of reality? This paper shows that the heuristic can indeed be rationalized. Contrary to conventional wisdom, however, the key mechanism is not the risk of de-anchoring inflation expectations, but sufficiently strong real wage rigidity. This suggests that monitoring the extent of real wage rigidity is at least as important as monitoring inflation expectations to assess the need for a hawkish pivot.
The paper's first main result is that de-anchoring risks do not significantly alter the optimal policy recommendations of the standard model. In response to productivity, labor supply, and energy price shocks, stabilizing the output gap remains very close to optimal, regardless of the persistence of the shocks (see middle panel of the figure).
The reason output-gap stabilization remains nearly optimal is ultimately the same as in the standard model with fully anchored expectations. When there are both price and wage rigidities, monetary policy does not have much impact on the real wage. What it does affect is whether a decrease in the real wage occurs through price increases or wage decreases, or any combination of the two. But stabilizing the output gap turns out to deliver a very good split between price increases and wage decreases, which minimizes the costs of price and wage inflation, all while avoiding fluctuations in the output gap. De-anchoring risks do not challenge this logic.
The paper's second main result is that while de-anchoring risks per se do not rationalize a hawkish pivot when supply shocks are persistent, something else does: a sufficient degree of real wage rigidity. Real wage rigidity can be interpreted as capturing explicit or implicit cost-of-living adjustments (COLA) whereby nominal wages catch up with prices when inflation would otherwise erode real wages. I show that if real wage rigidity is sufficiently high, stabilizing the output gap against persistent non-markup shocks becomes very costly (see right panel of figure). As a result, the optimal policy shifts from stabilizing the output gap when the shock is transitory to stabilizing price inflation more when the shock is persistent. This rationalizes central banks' supply shock heuristic, but applies even if inflation expectations are rational and cannot de-anchor.
What real wage rigidity changes is that stabilizing the output gap no longer splits a decrease in the real wage between price increases and wage decreases. Instead, when real wages are sufficiently rigid, prices and wages move in the same direction. This generates substantial inflation in both prices and wages. To limit these distortions, monetary policy becomes willing to tolerate a negative output gap. The incentive to do so increases with supply shock persistence, because the inflation-wage comovement becomes more prolonged.
Keywords: Supply Shocks ; De-Anchoring ; Real Wage Rigidity.
Codes JEL : E52, E31, E58
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Updated on the 23rd of July 2026