What drives inflation? Disentangling demand and supply factors

Summary

Focus 

Disentangling demand and supply factors driving inflation has often been a major challenge for monetary policy. This is also the case currently, as there are different views on the relative role of demand and supply in the inflation surge since 2021. In this paper, we estimate demand and supply factors and assess their contribution to inflation dynamics in the United States over the past five decades. The analysis also covers the euro area over the past two decades.

Contribution 

We take a novel approach to disentangling supply and demand factors in inflation and real activity dynamics. Based on a structural factor model comprising more than 140 quarterly time series measures of inflation and real activity in the United States going back to 1970, we identify aggregate demand and supply factors. That way, we obtain indicators of aggregate demand and supply conditions and can assess their role in the dynamics of inflation.

Findings 

The results provide a narrative of the evolution of the stance of demand and supply in the United States over the past five decades. The most recent estimates indicate that the inflation surge since mid-2021 has been driven by a combination of extraordinarily expansionary demand conditions and tight supply. We obtain similar results for the euro area, but with a somewhat greater role for tight supply consistent with the greater exposure of the euro area to recent adverse global energy price shocks. We further find that monetary policy and financial shocks affect both demand and supply.

Abstract

We estimate indicators of aggregate demand and supply conditions based on a structural factor model using a large number of inflation and real activity measures for the United States. We identify demand and supply factors by imposing theoretically motivated sign restrictions on factor loadings. The results provide a narrative of the evolution of the stance of demand and supply over the past five decades. The most recent factor estimates indicate that the inflation surge since mid-2021 has been driven by a combination of extraordinarily expansionary demand conditions and tight supply conditions. We obtain similar results for the euro area, but with a somewhat greater role for tight supply consistent with the greater exposure of the euro area to recent adverse global energy price shocks. We further find that tighter monetary policy and financial conditions dampen both demand and supply conditions.

JEL classification: E3, E5, E6, C3.

Keywords: inflation, aggregate demand and supply, factor model, sign restrictions, monetary policy.