ECB study links inflation surge to production network effects

The sharp rise in post-pandemic inflation is better explained by the economy's production network and 'state-dependent' pricing, where firms adjust prices when the reward justifies the effort.

Firms are tightly linked through supply chains, meaning a price shock upstream can trigger simultaneous repricing by many downstream firms.

This 'pricing cascade' can turn a contained shock into a broad inflationary episode.

Standard models often assume mechanical price updates, but real-life data shows firms choose optimal times to adjust prices due to effort involved.

Combining these mechanisms reveals why inflation reacts more suddenly to supply-side shocks than to demand-side shocks, a key finding of the study.

Demand-side shocks, such as monetary or fiscal expansion, typically lead to gradual price adjustments, as production networks tend to slow down the transmission of cost increases.

Conversely, supply shocks, like a substantial increase in crucial input costs, trigger rapid pricing cascades.

This incentivizes many firms to reprice simultaneously, leading to sharp and rapid inflationary surges.

Applied to the euro area with post-pandemic shocks, the model successfully reproduced both the sharp rise in inflation to around 11 percent and the unusually rapid rate of price adjustments by firms, outperforming simpler models.