Second-Round Effects of Inflation

The second-round effects of a supply shock occur when its initial price rise spreads into subsequent wage-setting, price-setting and inflation expectations. Unlike the direct impact of a costlier or scarcer commodity, these responses can make inflation broader and more persistent, even after the original shock has faded.

From the initial shock to wider inflation

An adverse supply shock, such as a poor harvest or an increase in imported oil prices, initially raises the prices of affected goods. This changes relative prices and raises measured inflation, but does not necessarily generate continuing inflation.

• The first-round effects include the direct price increase and its mechanical transmission through production costs, such as higher fuel costs raising transport charges.
• The second-round effects arise when workers and firms respond to higher actual or expected inflation by adjusting wages and prices beyond this initial cost transmission.
• A one-time rise in the price level does not, by itself, imply a permanently higher inflation rate.

How second-round effects develop

The central mechanism is a feedback between inflation expectations, wage demands and firms' pricing decisions. Such feedback is possible, not inevitable.

• Workers may seek higher nominal wages to restore purchasing power lost through rising living costs.
• If wage increases raise unit labour costs, firms may increase selling prices to protect margins.
• Firms expecting further increases in input costs may raise prices pre-emptively rather than wait for those costs to materialise.
• Repeated wage and price adjustments can create a wage-price spiral, extending inflation beyond the goods originally affected.

What determines persistence and the policy response

Second-round effects are stronger when shocks recur, expectations become less anchored, and economic conditions allow higher costs to be passed on. Their strength also depends on wage-setting arrangements, productivity and firms' pricing power.

• Anchored expectations mean that people continue to expect inflation to return towards the central bank's objective despite a temporary shock.
• Monetary policy cannot directly produce scarce food or energy, but it can restrain demand and influence expectations to limit persistent wage-price feedback.
• The policy trade-off is that tightening against a supply shock may further weaken output; ignoring spreading inflation may allow it to become entrenched.
• Supply-side measures can address the original shortage, while credible policy communication can help prevent temporary price increases from reshaping longer-term expectations.