Euro area inflation surge driven by persistent domestic supply and transitory demand shocks
A Bank of England working paper reveals that domestic supply shocks drove persistent euro area inflation to 3 percent by 2022. Demand shocks, both global and domestic, explain 85 percent of the post-COVID inflation surge through transitory components.
Persistent and transitory drivers
The study investigates the post-COVID inflation surge in the euro area, decomposing long-term trends and business-cycle dynamics.
It finds that domestic supply shocks significantly fed into the persistent component of euro area inflation, pushing trend inflation to 3 percent by the second quarter of 2022. In contrast, demand shocks, both domestic and global, primarily manifested in the transitory component, or inflation gap.
These demand-side factors are identified as explaining a substantial 85 percent of the total post-COVID inflation surge.
This distinction is crucial for understanding the nature of inflationary pressures and aligns with the ECB's revised monetary policy strategy.
Unpacking inflation's structural channels
The study develops a novel framework that decomposes euro area inflation into persistent (trend) and transitory (gap) components.
Unlike prior literature, it identifies structural shocks by their persistence and domain (global vs. domestic, demand vs. supply, energy-specific).
The model also incorporates time-varying volatility and fat-tailed distributions to accurately capture extreme observations, such as those seen during the COVID-19 pandemic.
This integrated approach provides a more granular understanding of how different shocks impact the long-term and short-term dynamics of inflation.
Crucial clarity for policymakers
This research provides invaluable clarity for central bankers navigating complex inflation environments.
By distinguishing between persistent and transitory drivers, it offers a more precise compass for monetary policy decisions.
Understanding these dynamics is essential to avoid overreacting to temporary shocks or underestimating long-term inflationary shifts.