Understanding post-Covid inflation dynamics

This paper was produced as part of the BIS Consultative Council for the Americas (CCA) research conference on "Structural changes in inflation and output dynamics after Covid and other shocks", held in Mexico City on 17–18 November 2022.

Summary

Focus 

Inflation rose sharply after the Covid-19 pandemic hit. A large body of empirical evidence documents that the Phillips curve has flattened over past decades. This raises the question whether the Phillips curve has recently steepened or if large exogenous demand and supply factors are the key to understanding post-Covid inflation dynamics. We seek to answer this question using a workhorse macroeconomic model.

Contribution 

We propose a model that can jointly account for the modest decline in inflation during the Great Recession and the surge in inflation during the post-Covid period. Most macroeconomic models struggled to explain the sharp rise of inflation during the post-Covid period. Understanding inflation dynamics and its implications for monetary policy remains a top priority for policymakers.

Findings 

Our model features a non-linear Phillips curve that has a flat slope when inflation is low but steepens when inflation is high. This is because firms increase prices more aggressively when marginal costs increase than they cut prices when marginal costs fall. All shocks in the model transmit stronger to inflation when inflation is high. Cost-push shocks propagate even more strongly to inflation than do demand and technology shocks when inflation is high, producing inflation volatility and risk. Hence, our model can generate more sizeable inflation surges due to cost-push and demand shocks than does a standard linearised model. This improves forecasting performance during the post-Covid period. Finally, our model implies that the central bank faces a steeper trade-off between inflation and output stabilisation when inflation is high. Specifically, when inflation is high to begin with, stabilising inflation in response to a cost-push shock requires a larger interest rate increase and larger output drop.

Abstract

We propose a macroeconomic model with a nonlinear Phillips curve that has a flat slope when inflationary pressures are subdued and steepens when inflationary pressures are elevated. The nonlinear Phillips curve in our model arises due to a quasi-kinked demand schedule for goods produced by firms. Our model can jointly account for the modest decline in inflation during the Great Recession and the surge in inflation during the Post-COVID period. Because our model implies a stronger transmission of shocks when inflation is high, it generates conditional heteroskedasticity in inflation and inflation risk. Hence, our model can generate more sizeable inflation surges due to cost-push and demand shocks than a standard linearized model. Finally, our model implies that the central bank faces a more severe trade-off between inflation and output stabilization when inflation is high.

JEL Classification: E30, E31, E32, E37, E44, E52

Keywords: Inflation dynamics, inflation risk, monetary policy, linearized model, nonlinear model, real rigidities