The real cause of post-pandemic inflation was demand, not supply, argues new research

The real cause of post-pandemic inflation was demand, not supply, argues new research

A new research paper argues that the driver of a surge in post-pandemic inflation on both sides of the Atlantic was demand, not supply.

At the European Central Bank annual gathering in Sintra, Portugal, economists Domenico Giannone of the International Monetary Fund and Giorgio Primiceri of Northwestern University say the predominant view that supply-chain disruptions were mostly to blame was not accurate.

“This popular narrative is difficult to square with all the evidence,” they said in a paper presented at the same conference where Federal Reserve Chair Jerome Powell is due to speak.

The economists say both the U.S. Federal Reserve and the European Central Bank are effective inflation targeters, which in turn results in a flat aggregate demand curve.

“But if the demand curve is flat, left shifts in the supply curve depress output but cannot produce much inflation. For inflation to climb, the demand curve must shift upwards, due to demand shocks or temporary deviations from the central bank’s previous conduct of monetary policy,” they say.

And that is what they say happened, in both the U.S. and Europe.

When it comes to U.S. inflation, more than half of its rise and fall can be attributed to demand disturbances, they say. A similar picture was painted for Europe, with the difference being that supply factors weighed even more on GDP, while demand shocks played a bigger role in inflation.

The researchers said the finding that demand rather than supply holds even with many changes to the model, using different measures of activity and prices, or adding energy prices and monetary variables.

The researchers also comment on a separate study done by former Fed Chairman Ben Bernanke and former International Monetary Fund chief economist Olivier Blanchard, who found a large impact of food and energy prices on aggregate inflation. They say that their conclusions are not necessarily in conflict, because energy prices are largely driven by the same fluctuations in aggregate demand that have ultimately generated inflation.

Given their findings, they also simulated what would’ve happened if the ECB had followed a stricter policy. If the ECB completely neutralized the impact of all demand shocks, inflation would have peaked at only 3%, but gross domestic product would have tanked, with a cumulative loss of 4%. A stricter policy where ECB interest rates were raised to the same level, but earlier, would have seen inflation peak at 6%, at an output loss of 1%.

The researchers did not conduct a similar analysis on U.S. monetary policy.

Back in the real world, their model predicts what they call “an easy last kilometer” in bringing inflation down. “Regarding the medium term, we find that the ECB has not experienced any significant damage or loss of credibility from the accommodation during the pandemic; in fact, the public believes that policy has returned to its pre-Covid norm,” they say.

Inflation data released Tuesday by Eurostat showed annual inflation easing to 2.5% in June, meeting economist estimates, from 2.6% in May.

The ECB made its first interest rate cut of the cycle in June.