Upside inflation risks create persistent stagflation
Shifts in the asymmetry of inflation risks generate persistent stagflationary dynamics by raising prices and depressing real economic activity, according to research from the Banco de España. The authors demonstrate that central banks should preemptively lean against inflation skewness.
Stagflationary drag from upside skew
Analyzing U.S. core PCE inflation from 1960 to 2024 with a Skew-t unobserved components model reveals that inflation risk asymmetry is highly time-varying and persistent.
Revisions in inflation skewness behave like adverse supply disturbances: an upward shift in upside risk increases inflation while depressing real GDP and total hours worked, while policy rates react only modestly.
The authors introduce a representation theorem proving that models with time-varying asymmetric shock distributions can be cast to a first-order approximation as standard linear systems driven by belief shocks.
This mean-mode wedge captures shifting tail risks, which closely mirror international trade fragmentation.
Three phases of risk adjustment
Optimal policy requires monetary authorities to actively lean against risk imbalances rather than managing modal forecasts alone.
The proposed Risk-Adjusted Inflation Targeting framework adjusts rate paths and forward guidance to neutralize belief distortions.
In a post-pandemic counterfactual, this strategy prescribes raising interest rates in 2021Q2—three quarters earlier than the Federal Reserve acted—before moderating forward guidance in 2023 and easing in 2024.
Elegant theory meets noisy data
The paper provides an elegant mathematical bridge between central bank risk management and formal policy rules.
Yet extracting reliable skewness metrics in real time remains an operational hazard prone to false alarms.
Prematurely tightening on noisy tail signals could inflict unnecessary output losses during supply shocks.