After a pointy decline within the first few months of the COVID-19 pandemic, inflation rebounded within the second half of 2020 and surged by 2021. This put up analyzes the drivers of those developments by the lens of the New York Fed DSGE model. Its most important discovering is that the current rise in inflation is generally accounted for by a big cost-push shock that occurred within the second quarter of 2021 and whose inflationary results persist right this moment. Based mostly on the mannequin’s studying of historic information, this shock is predicted to fade regularly over the course of 2022, returning quarterly inflation to shut to 2 p.c solely in mid-2023.
Earlier than delving into the evaluation, we want to remind our readers that the DSGE mannequin forecast isn’t an official New York Fed forecast, however solely an enter to the Analysis employees’s general forecasting course of.
The Surge in Inflation
The chart beneath reveals in crimson the evolution of the 12-month inflation charge within the Private Consumption Expenditures (PCE) worth index excluding meals and vitality (core PCE) since 2000. Its current enhance is particularly placing in opposition to the backdrop of extraordinarily steady inflation round 2 p.c within the earlier 20 years. The chart additionally studies the measure of inflation that the remainder of this put up focuses on: the quarterly annualized share change within the core PCE worth index. That is the measure of core inflation used within the estimation of the New York Fed DSGE as a result of this mannequin is devised to account for information, similar to GDP progress, that are solely accessible at a quarterly frequency. The rise in inflation over the previous 12 months is equally evident in our quarterly measure as within the extra acquainted 12-month change.
Two Measures of Core PCE Inflation
The Position of Value-Push Shocks
What elements underlie this surge in inflation? DSGE fashions are particularly helpful instruments to deal with this sort of query as a result of their construction allows economists to decompose the evolution of key macroeconomic variables, similar to inflation on this case, when it comes to underlying driving forces, as mentioned in some element in this Liberty Street Economics post centered on the Nice Recession. The chart beneath reveals such a decomposition, specializing in core PCE inflation in deviation from 2 p.c. Along with information from 2017 to the fourth quarter of 2021, the chart additionally shows the mannequin’s forecast of this variable by the tip of 2024. This decomposition highlights the contribution to the actions in inflation coming from 5 teams of shocks: 1) cost-push shocks that hit the economic system earlier than 2020; 2) cost-push shocks that hit the economic system in 2020; 3) cost-push shocks that hit the economic system in 2021; 4) transitory worth degree shocks; and 5) COVID-19-related shocks. By cost-push shocks, we imply shocks to the worth Phillips curve that determines inflation within the mannequin, versus shocks that transfer inflation by their impact on marginal prices. In our mannequin, marginal prices rely upon productiveness, actual wages, and the price of capital. Due to this fact, any disturbance that impacts inflation apart from instantly by these channels represents a cost-push shock. For example, shocks to the worth of vitality or different intermediate inputs, together with these as a consequence of bottlenecks in the supply chain, could be captured by this shock.
The Affect of Value-Push Shocks on Core PCE Inflation and Its Forecast
The important thing distinction between cost-push shocks and transitory worth degree shocks in our mannequin is that the consequences of the previous on inflation are persistent. This persistence is partly endogenous, because the mannequin’s Phillips curve contains lagged inflation, and partly as a consequence of the truth that cost-push elements observe an autocorrelated course of, whose persistence is estimated utilizing information since 1964. In distinction, transitory worth degree shocks have stationary results on the worth degree, which impart destructive auto-correlation to inflation. Following one such shock, inflation is above common at first, however ultimately falls beneath common, as costs return to their authentic degree earlier than the shock. COVID-19 shocks are extra temporary shocks added to the model to account for the very excessive dynamics noticed in most actual variables on the outset of the pandemic.
Two Inflation Narratives
By together with each transitory and protracted pricing shocks, the mannequin encompasses two key narratives which have animated the controversy on the sources of inflation over the previous 12 months. The primary narrative noticed inflationary pressures as largely transitory, whereas the second instructed that they could persist within the medium time period.
The shock decomposition introduced within the chart above factors within the route of this second narrative, with cost-push shocks driving inflation steadily larger over the course of 2021 after which fading solely regularly over the following two years. A number of different elements of this shock decomposition are price noting. Transitory shocks dominated the actions of inflation early within the pandemic, because it first plunged within the second quarter of 2020 and subsequently rebounded within the third quarter because the economic system shut down and the re-opened. Persistent cost-push shocks have been just about absent in that first section of the pandemic economic system.
The image modifications drastically in 2021, particularly within the second quarter, when the mannequin attributes about 2.5 share factors of the surge in inflation to new cost-push shocks. The short-term worth degree shock contributes one other 1.5 share level to inflation within the second quarter, with a a lot smaller contribution within the third quarter. However this moderating impact is swamped by the dimensions and persistence of the cost-push shocks hitting within the first half of the 12 months. These shocks dominate the present inflation image, imparting vital persistence to the forecast.
The distinction between the model-based decomposition of the drivers of inflation in 2020 and 2021 means that the mannequin can distinguish between totally different sources of inflation. Persistent cost-push shocks are an vital supply of inflation variation within the mannequin, as additionally proven by the bars within the interval as much as 2019. However they’re removed from capable of clarify all its fluctuations. They account for about half of the variance of inflation at excessive frequencies and much much less at decrease frequencies. Total, cost-push shocks are liable for about 20 p.c of its unconditional variance. But, the mannequin ignores cost-push shocks virtually completely in 2020, whereas they dominate the scene in 2021. This distinction between the inflation drivers recognized by the mannequin in 2020 and 2021 means that its conclusion relating to the anticipated persistence of the present inflation shock isn’t hardwired into its assumptions.
COVID-19 shocks have negligible results on inflation, for 2 causes. First, in line with the mannequin’s New Keynesian Phillips curve, inflation is dependent upon the current discounted worth (PDV) of future marginal prices, relatively than on their present degree alone. Transitory shocks to these marginal prices, even when massive, have restricted impact on their PDV. Second, the Phillips curve within the mannequin is estimated to be very flat. Due to this fact, even massive actions within the PDV of marginal prices have a small affect on inflation. This low estimated pass-through from actual financial developments to inflation explains why, pre-COVID, inflation barely moved even within the face of enormous enterprise cycle shocks, such as during the Great Recession.
What About Different Shocks?
We’ve argued above that our mannequin doesn’t attribute all notable actions in inflation to cost-push shocks by development. The truth is, different drivers, together with combination demand shocks, are on common extra vital sources of inflationary pressures within the mannequin than cost-push shocks and in addition play an vital function within the mannequin’s decomposition introduced above. Earlier than 2020, cost-push shocks are likely to push inflation above 2 p.c, as proven by the optimistic gentle blue bars. But, inflation hovers beneath 2 p.c in that interval, indicating that different elements are restraining it. After 2020, this restraining pressure is generally gone: inflation is larger than the sum of the bars, suggesting that the opposite shocks at the moment are pushing it up. Nonetheless, this shift is gradual and it doesn’t clarify the spike in inflation in 2021. That is partly due to the mannequin’s flat Phillips curve, which means that the enhance to combination demand should be excessive and/or persistent to have a large impact on inflation.
Caveats and Conclusions
The identification of the elements driving inflation is just pretty much as good because the mannequin that produces it, and our mannequin is omitting many related elements of actuality. A probably vital one is fiscal coverage. In our mannequin, the big fiscal transfers enacted throughout the pandemic haven’t any direct impact on consumption as a result of its consultant family anticipates the rise in taxes that may ultimately be essential to pay for them. This is able to not be the case in a mannequin with heterogenous brokers, a few of whom are hand-to-mouth and thus exhibit excessive marginal propensities to eat, as an example. In such a mannequin, the enhance to consumption demand from fiscal stimulus could be bigger than in our framework.
The mannequin additionally abstracts from one other much-discussed characteristic of the present atmosphere: the imbalance between the calls for of products, particularly durables, and providers. Qualitatively, this hole within the mannequin shouldn’t considerably have an effect on our conclusions as a result of sectoral shocks have very comparable results to cost-push shocks in fashions just like ours, as proven most lately here. Quantitatively, although, the intense sectoral imbalances noticed throughout the pandemic would possibly end in extra persistent cost-push shocks than these noticed traditionally and that inform the mannequin’s estimates.
In sum, the mannequin’s evaluation is that the elevated inflation noticed over the previous 12 months is generally pushed by persistent cost-push elements. In our subsequent put up, we focus on how different financial coverage methods contribute to form the response of the economic system to those shocks.
Marco Del Negro is a vp within the Financial institution’s Analysis and Statistics Group.
Aidan Gleich is a senior analysis analyst within the Financial institution’s Analysis and Statistics Group.
Shlok Goyal is a senior analysis analyst within the Financial institution’s Analysis and Statistics Group.
Alissa Johnson is a senior analysis analyst within the Financial institution’s Analysis and Statistics Group.
Andrea Tambalotti is a vp within the Financial institution’s Analysis and Statistics Group.
The views expressed on this put up are these of the authors and don’t essentially replicate the place of the Federal Reserve Financial institution of New York or the Federal Reserve System. Any errors or omissions are the accountability of the authors.