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Systemic inflation drivers (and what to do about them)

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In the ongoing quest to write about all the interesting stuff that has gotten overshadowed by the FTX shit vortex in recent weeks, it is time to turn to a fascinating paper on “systemically significant” inflation.

In other words, not all price increases are created equal. Some are far more influential for overall inflation rates than their weightings would imply, because of their role as inputs in swaths of the broader economy.

This makes intuitive sense. But perhaps most importantly, many of these systemically important prices are actually hard if not impossible for monetary policy to influence, and require more fine-tuned micro-policy responses to quell.

Here is the abstract from the paper authored by Isabella Weber, Jesús Lara Jauregui, Lucas Texeira and Luiza Nassif Pires:

In the overlapping global emergencies of the pandemic, climate change and geopolitical confrontations, supply shocks have become frequent and inflation has returned. This raises the question how sector-specific shocks are related to overall price stability. This paper simulates price shocks in an input-output model to identify sectors which present systemic vulnerabilities for monetary stability in the US. We call these prices systemically significant.

We find that in our simulations the pre-pandemic average price volatilities and the price shocks in the COVID-19 and Ukraine war inflation yield an almost identical set of systemically significant prices. The sectors with systemically significant prices fall into three groups: energy, basic production inputs other than energy, basic necessities, and commercial and financial infrastructure. Specifically, they are “Petroleum and coal products”, “Oil and gas extraction”, “Utilities”, “Chemical products”, “Farms”, “Food and beverage and tobacco products”, “Housing”, and “Wholesale trade”.

We argue that in times of overlapping emergencies, economic stabilization needs to go beyond monetary policy and requires institutions and policies that can target these systemically significant sectors.

This runs counter to the common economic dogma that inflation is a purely macroeconomic issue, which monetary policy is the best — perhaps only — tool to tackle.

As the tiresomely repeated Milton Friedman quote goes, “inflation is always and everywhere a monetary phenomenon”. And as the paper points out, even New Keynesians see it as a product of aggregate demand and capacity utilisation. But wars, droughts and trade tiffs are hard things for central banks to resolve.

The economists simulated shocks to each of the 71 industries in the US Bureau of Economic Analysis’s input-output table, using shifts in prices between 2000 and 2019 to identify the “systemically significant” drivers of overall inflation. Here is what they found:

As you might expect, the food and energy industries are the most important direct and indirect drivers of inflation. So even if you use a “core” CPI measure that strips them out, their impact will still be significant. And it is questionable how much monetary policy can really affect demand for them.

The implications for today are pretty obvious. If monetary policy is of limited impact on these systemically significant inflation drivers, should central banks really overcompensate, ratchet up rates aggressively and destroy demand to drive down all other prices — no matter what the economic cost?

Isabella Weber, economics professor at the University of Massachusetts and lead author of the paper, has a good thread summing up their findings here, but we recommend people check out the full paper.

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