The origins of inflation are not always well understood. While some economists had warned of impending inflation as early as last year, few had anticipated the dramatic shift in spending from services to goods and the effects of such a shift. The fact that inflation expectations remain subdued is likely due to rational inattention. In the absence of monetary tightening, we believe that inflation expectations would inevitably get de-anchored.
The return of inflation has become the central economic issue. Public policies and financial markets depend on its level and expected trend.
Yet its origin is not always well understood. The most striking fact since the beginning of the year is the forecasting error made by professional economists. In recent months, they have repeatedly revised their inflation forecasts upwards and their economic growth forecasts downwards, first for 2022 and more recently for 2023.
While some economists had warned of impending inflation as early as last year, few had anticipated the dramatic shift in spending from services to goods and the effects of such a shift in an economy where labour shortages in some sectors have led to persistent supply constraints. Recall that in the spring of 2021 the Fed was forecasting peak inflation at 2.4% and that in Europe inflation was not even a concern last autumn.
The combination of supply and demand shocks since the Covid-19 crisis, as well as policy mixes put in place, have rendered econometric models inoperative. The experience of stagflation in the 1970s had already led to a reconsideration of some of the assumptions used in the models at that time. Robert Lucas’ critique (1976) suggests that the use of parameters based on past experience does not allow for an assessment of the effects of changes in macroeconomic policies. If these policies are changed, then the way in which expectations are formed may change, so that the forecast made using a model calibrated with different policies is inaccurate.
The relative importance of aggregate demand and supply shocks differs across countries. In the recent period, aggregate demand factors have played a more important role in explaining US inflation, while negative supply shocks – supply bottlenecks and energy price shocks – have tended to play a dominant role in Europe, at least up to now. In Europe, one of the first sources of forecasting error was the trend of energy prices, especially natural gas prices, which is an exogenous (unpredictable) factor for economists. Initially, the price increase was therefore seen as a temporary supply shock that would dissipate as energy prices stabilised and supply chains normalised.