Large energy shocks trigger non-linear inflation, demanding differentiated policy
A new European Central Bank Working Paper finds that euro area inflation reacts disproportionately to large energy shocks, while small shocks have no significant effect. This non-linear transmission implies a need for differentiated monetary policy responses.
Inflation's disproportionate response to energy
Applying a novel empirical structural inflation model to euro area energy shocks, researchers found that inflation reacts disproportionately to large shocks, while small shocks trigger no significant response.
These non-linearities are present along the entire pricing chain, being more pronounced upstream for commodity and producer prices and gradually attenuating downstream for consumer prices.
Unlike traditional linear models, this approach captures non-linear effects at all impulse response horizons, revealing that large shocks amplify their transmission to inflation, a crucial insight missed by prior models during the post-pandemic surge.
The study highlights that these non-linearities increase smoothly with shock sizes, suggesting that models with few regime shifts may oversimplify actual inflation dynamics.
Unpacking non-linearities with machine learning
The paper develops a novel econometric framework for modelling euro area inflation, leveraging traditional time series models and machine learning techniques.
It blends a Bayesian Vector Regression (BVAR) with Bayesian Additive Regression Trees (BART) to allow reduced-form errors to be non-linearly driven by structural shocks.
This addresses a significant gap in the literature, as previous machine learning applications for structural analysis often restricted impact reactions to be linear.
The model identifies four structural shocks – energy, global supply chains, demand, and domestic supply – with non-linearities found to be most relevant for energy price shocks, a key driver of post-pandemic inflation forecast errors.
Beyond 'looking through' small shocks
The finding that large shocks transmit differently implies a critical shift for monetary policy.
While central banks can often afford to 'look through' small supply shocks, the study clearly demonstrates that larger ones cannot be ignored without risking significant inflation deviations.
This research provides a robust empirical basis for a more nuanced, size-dependent approach to monetary policy in the face of cost-push pressures.