A Conditional Answer to “Look Through”

The central question is when a central bank should look through an energy shock. The answer supported by the evidence is conditional: a central bank can allow a temporary first-round energy-price movement to pass when broader inflation remains contained and the activity damage is manageable, but it should be more willing to act when the shock is persistent, large, or spreading into expectations and underlying prices. The judgment must be made in the context of a particular economy and updated as the evidence changes; neither a headline oil price nor a single market forecast is enough.

Looking Through Is a Judgment About a Chain, Not a Price

An energy shock begins as an event in the physical economy, but monetary policy is concerned with the chain that follows. A conflict can disrupt oil and gas supply, raise energy costs, and put pressure on production. Households lose purchasing power as energy takes a larger share of their income. Firms face higher input costs and may reduce margins, raise prices, or cut production. Financial conditions can worsen as markets reassess growth and the likelihood of further disruption. The first effect may be supply-driven, but the economy’s response can add demand weakness, expectation changes, and broader inflation.

That is why classification is necessary but not sufficient. A demand shock initially changes consumption, investment, government spending, or net exports without directly changing productive capacity. A supply shock affects production processes, markets, or the available productivity of labour and capital. The same energy event can contain both: supply is disrupted first, then real income falls and spending weakens. A separate force, such as trade-policy change or investment optimism around AI, can push demand or potential output in the other direction. The categories organize the diagnosis, but they do not remove uncertainty about what is happening at the same time.

The output gap connects this diagnosis to the central bank’s objectives. Actual output is compared with an estimate of potential output, the level the economy can sustain over the long run while maintaining price stability and maximum employment. When output is above potential, excess demand tends to put upward pressure on inflation and employment may run above its sustainable level. When output is below potential, employment and inflation may both weaken. An energy supply shock can lower potential output, lower actual output, or do both. It can therefore raise inflation while reducing the economy’s capacity and the purchasing power available to households.

The policy implication depends on whether inflation and activity move together or apart. If demand is excessive and both inflation and employment are too high, tightening can support both objectives by cooling the economy. If output is weak and inflation is low, easing can support both. But an energy supply disruption can raise prices while weakening real income and production. Tightening may prevent the initial price movement from becoming persistent, yet it may also deepen the activity loss. Easing may protect output, yet it may add demand while supply remains constrained.

The phrase “look through” belongs in this tension. It does not mean ignoring the energy increase or denying its effect on living costs. It means judging that the direct movement is likely to reverse or remain contained before monetary policy can materially affect the economy, and therefore not trying to offset every first-round change with higher rates. The choice is defensible only if the central bank also judges that expectations and broader price-setting will remain stable enough while it waits.

Persistence is the hinge. If alternative supplies appear, the conflict eases, or reserves prevent a prolonged shortage, the price movement may reverse. If infrastructure damage, a major chokepoint, or uncertain access to substitutes keeps the disruption alive, the price may remain volatile or rise again. Even when the commodity price falls, earlier cost increases may already have affected firms’ prices, wages, and expectations. A price reversal is relevant evidence, but it is not a complete account of the inflation process.

Monetary policy’s lag makes the forecast unavoidable. A rate change takes time to influence demand and expectations. If the energy shock ends before that influence arrives, an aggressive response can restrain spending after the supply problem has faded. If the shock lasts long enough for households and firms to change their behaviour, waiting can make the later response more costly. The decision is consequently about the joint path of energy prices, underlying inflation, expectations, output, and employment—not about predicting one commodity price with certainty.

The full model can be stated as a loop rather than a one-time decision:

flowchart TD A["Classify supply and demand effects"] --> B["Estimate persistence and pass-through"] B --> C["Assess inflation expectations"] B --> D["Assess output and employment trade-off"] C --> E["Adjust for structure and starting conditions"] D --> E E --> F["Choose and update policy stance"] F --> G["Look through while effects remain contained"] F --> H["Act sooner or reassess when persistence rises"] G --> I["New evidence"] H --> I I --> B

Country structure and starting conditions determine how the loop should be read. For an energy importer, a higher world price can worsen the terms of trade, reduce national purchasing power, and weaken the currency. Depreciation can make imported energy and other goods more expensive.