Pandemic inflation surge driven by supply and demand factors
A new ECB working paper finds that the euro area's pandemic-era inflation surge was driven by a combination of supply and demand factors. Accommodative fiscal and monetary policies contributed but were not the dominant drivers.
The BVAR model's insights
The study employs a Bayesian Vector Autoregression (BVAR) model, utilizing narrative, sign, zero, and inequality restrictions, to disentangle the complex drivers of euro area inflation from 2021-2023.
This approach is the first to jointly analyze the inflationary effects of energy and non-energy supply, as well as policy and non-policy demand factors, including fiscal policy and both conventional and unconventional monetary policy.
It reveals that the surge, which saw headline inflation rise from below 1 percent in January 2021 to a peak above 10 percent in October 2022, was a multifaceted phenomenon, with no single factor clearly dominating.
Accommodative fiscal and monetary policies collectively contributed approximately 1.5 percentage points to this peak, with fiscal policy accounting for 0.6 percentage points and monetary policy (both conventional and unconventional) for 0.9 percentage points.
Genuine energy-related supply-side constraints, even if less important than often estimated, were a key factor, adding about 2.4 percentage points to peak inflation.
Non-policy demand and non-energy supply shocks contributed an additional 3 percentage points.
The model incorporates a broad range of macroeconomic variables, including inflation, energy prices, GDP growth, interest rates, government expenditure, and pandemic-era supply-demand imbalances, to achieve robust identification of these shocks.
Counterfactuals and disinflation dynamics
A key finding from the study's counterfactual analysis is that an earlier monetary policy tightening, specifically aimed at nullifying its inflationary contribution, would have only marginally reduced the euro area's headline inflation peak to 8.5 percent, from the actual 10 percent.
Crucially, this would have come at the significant cost of substantial output losses, with average economic growth falling by 3.6 percentage points relative to its realized path.
This highlights the difficult trade-offs faced by policymakers during the crisis.
The paper also meticulously details the disinflation process observed after October 2022, which saw inflation gradually decline to 2.9 percent by December 2023.
This reduction was attributed to a combination of factors, including tightening monetary policy (reducing inflation by 1 percentage point), more favorable energy supply conditions (reducing inflation by approximately 2 percentage points), fiscal tightening (lowering inflation by about 0.6 percentage points), and the gradual fading of supply-and-demand imbalances characteristic of the pandemic environment.
Furthermore, the research provides a nuanced view on energy prices, indicating that genuine energy-supply shortages accounted for only about 15 percentage points of the 30 percent peak in euro area energy price inflation, with the remaining half largely driven by demand-side factors, both policy-induced and non-policy.
Nuanced view on policy's role
This study offers a crucial, nuanced perspective on the pandemic's inflation drivers, challenging simpler narratives that overemphasize policy or supply.
While its BVAR model is robust, the counterfactual analysis highlights the difficult trade-offs policymakers faced.
The findings underscore the complexity of attributing inflation solely to monetary policy, offering valuable lessons for future crisis responses.