New index identifies inflation shock momentum, forecasts PCE

Researchers Kevin J. Lansing and Adam Hale Shapiro developed a non-parametric filter to identify sustained directional runs in shocks to monthly inflation, termed 'inflation shock momentum.'

By analyzing over 100 disaggregated Personal Consumption Expenditures (PCE) inflation categories, they isolate the share of categories experiencing positive or negative momentum.

The 'Inflation Shock Momentum' (ISM) index is defined as the net positive momentum share of expenditure-weighted categories.

This index helps forecast aggregate PCE inflation at horizons of 1 to 3 years, even when controlling for other predictor variables.

The ISM index is particularly useful for capturing emerging disinflationary pressure and can forecast future inflation movements in real time, providing timely information not fully captured by standard variables.

The filter identifies sequences of three consecutive months where category inflation deviates positively or negatively from a benchmark data generating process, capturing recent persistent inflationary or disinflationary pressure.

The pandemic-era inflation episode highlighted the difficulty policymakers face in distinguishing between transitory and persistent inflation shocks in real time.

Delayed recognition risks de-anchored inflation expectations, while premature tightening can cause unnecessary output losses.

The ISM index aims to provide early and reliable indicators of shifts in the underlying inflation environment.

Unlike typical parametric estimates of persistence, the non-parametric ISM measure is sign-sensitive, distinguishing between persistent positive shocks that push inflation higher and persistent negative shocks that signal disinflationary forces.

It also uses only a short window of recent data, providing more timely information about current shock persistence compared to average values over longer periods.