By end-2007, consumer inflation had reached 8.4 percent, exceeding the 4-percent target. However, the fall of core inflation (which excludes items beyond the control of monetary policy such as food and energy) to 4.8 percent confirmed that the monetary tightening implemented in 2006 was the right policy choice. During this period, domestic demand and capacity conditions also continued to support the disinflation process. In early 2008 the supply side shocks in food and energy prices started to exert significant inflationary pressures, as they reached unprecedented levels above and beyond expectations. For instance, October 2007 Inflation Report, based on forecasts of international agencies, had foreseen oil prices around USD 70 per barrel in 2008 and a gradual correction in food prices. In other words, it was assumed that supply side shocks would be temporary and that they would lose impact after a while. These forecasts were in line with pricing in forward and futures markets. However, these expectations did not materialize. Both crude oil prices and agricultural commodity prices continued to rise. The adverse impacts of supply shocks reached unprecedented levels during the first half of 2008. 4  BIS Review 82/2008  Under normal circumstances, supply shocks are expected to have a temporary impact on relative prices, not changing the course of medium-term inflation. Nevertheless, the emergence of multiple shocks at the same time and their persistence for a considerable period aggravated the risks on pricing behavior.
The Central Bank has been implementing a monetary tightening to offset the secondary effects of supply shocks. Since domestic demand is growing at a moderate pace at the moment, it has been curbing the pass through from cost-push factors. As a matter of fact, the prices of products that do not use food or energy as main inputs have been rather well behaved compared to the prices of products that have food or energy as inputs. However, the fact that first round effects of the supply side shocks have reached unprecedented levels has been affecting inflation expectations adversely. Monetary policy cannot remain indifferent in case of a deterioration in the overall pricing behavior. If supply side shocks last long, their effects will spill over to the other sectors in the economy. A tighter stance is a must in order to control the expectations and to prevent the mutation of supply side shocks into demand shocks. If monetary policy does not react to the disruption in inflation dynamics, supply side price hikes may, after a certain point, easily evolve into a selffeeding vicious circle. Dear Guests, Why did the Central Bank not repeat the strong monetary tightening policy that it had implemented in 2006, but instead opted for a measured and gradual increase in interest rates in 2008? The current conditions differ from the May 2006 fluctuation.