High US inflation has become a central economic problem. It has produced an outpouring of analyses of why inflation has risen (as summarised by Anayi et al. 2022, among others) and how persistent the increase will be (e.g. Schmitt-Grohé and Uribe 2022). Thepurpose of this column is to shed light on both of these questions, drawing on our recent research (Ball et al. 2022).
We decompose headline inflation into two components: core (underlying) inflation, and deviations of headline from core. We seek to explain core inflation by long-term inflation expectations and the level of slack or tightness in the labour market, and to explain the non-core component of headline inflation by large price changes in particular industries. We also study the pass-through over time from these industry price shocks to core inflation, which can occur through the effects of headline inflation on wages and other costs of production.
Our primary measure of core is the weighted median inflation rate published by the Federal Reserve Bank of Cleveland, which strips out the effects of unusually large price changes in certain industries. This variable isolates the core component of inflation more effectively than the traditional core measure of inflation excluding food and energy prices, especially during the Covid-19 era, when much volatility in headline inflation has come from price changes in industries other than food and energy (Ball et al. 2021a).
In September 2022, core (weighted median inflation) accounted for 7.0 percentage points of the 8.2 headline inflation rate. Figure 1 shows both the 12-month and the monthly annualised inflation rate. Monthly headline inflation is highly volatile, reflecting fluctuations in the prices of energy, used cars, and other products.
Figure 1 CPI inflation: Headline, core, and headline-inflation shocks, 2020-2022 (%)
Note: Core inflation is median CPI inflation from the Federal Reserve Bank of Cleveland. Headline-inflation shocks denote deviations of headline inflation from core inflation.
Explaining the rise in inflation
We interpret the rise in core inflation as reflecting inflation expectations and tightness in the aggregate labour market, as in the textbook Phillips curve. Following recent studies such as Furman and Powell (2021) and Barnichon et al. (2021), we measure the tightness of the labour market by the ratio of job vacancies to unemployment.
We find that the very high levels of vacancies relative to unemployment over 2021-2022 can explain much of the rise in monthly core inflation, especially during 2022. The rest of the rise is explained by a substantial pass-through of headline-inflation shocks (deviations of headline from core) into core inflation.
These results help us understand why persistently high inflation has been a surprise to many economists – including us (Ball et al. 2021b) – who dismissed the run-up in inflation in mid-2021 as transitory.
These economists typically measured labour market tightness with the unemployment rate, which has only fallen to but not below pre-pandemic levels, and they ignored the pass-through effect that can propagate the effects of headline-inflation shocks.
Turning to the pandemic-era shocks to headline inflation – the deviations of headline from core – we find that they have contributed to inflation both directly and through the pass-through to core. Three factors have been most important in explaining this component of inflation: changes in energy prices; a measure of backlogs of work from the information services firm IHS Markit Economics, which we believe captures the widely reported problems with supply chains; and changes in prices in auto related industries.
A decomposition of the 6.9 percentage point rise in headline inflation between the end of 2020 and September 2022 (from 1.3% to 8.2%) indicates that the combination of direct and pass-through effects from headline-inflation shocks accounts for about 4.6 percentage points of the rise in 12-month inflation (Figure 2). Most of this 4.6 total reflects energy-price shocks and backlogs of work, with total contributions of 2.7 and 1.7 percentage points, respectively. There is also a significant pass-through from past auto-price shocks, reflecting the run-up in auto prices in the summer of 2021, but the direct effect on headline inflation has turned negative as these price increases have been partly reversed. A rise in expected inflation accounts for 0.5 percentage point, and the rise in labour market tightness (measured by the ratio of vacancies to unemployment) accounts for 2.0 percentage points, nearly a third of the total inflation increase. The rise in the ratio of vacancies to unemployment explains nearly one-half of the rise in core inflation, although, as we show in our paper, the effect is rising over time.
Figure 2 Accounting for the rise in headline inflation
(Decomposition of change in 12-month headline CPI inflation from December 2020 to September 2022; percentage points)
Note: Total rise in 12-month headline inflation is 6.94 percentage points (from 1.28% to 8.22%). The total rise in 12-month core (median) CPI inflation over this period is 4.63 percentage points (from 2.34% to 6.98%). ‘Expected inflation’ denotes contribution of change in long-term (SPF) inflation expectations to change in headline CPI inflation. ‘V/U’ denotes contribution of change in ratio of vacancies to unemployed. ‘Energy prices’ denotes contribution of relative energy prices. ‘Backlogs of work’ denotes contribution of change in index from IHS Markit Economics. ‘Auto prices’ denotes contribution of weighted average of auto-related prices. Based on estimates in Table 1 (column 4) and Table 2B (column 3).
Where is inflation heading?
What costs must be incurred for the Federal Reserve to meet its goal of reining in inflation? Fed officials have predicted a soft landing in which inflation returns to their target with only a modest increase in unemployment, while pessimists such as Summers (2022) believe that disinflation will require a painful recession with high unemployment. Which outcome is more likely?
In our view, the answer depends largely on two factors. One is the relationship between unemployment and vacancies – the Beveridge curve. This relationship has shifted unfavourably during the pandemic: a given level of vacancies implies a higher level of unemployment. The unemployment costs of reducing inflation will be substantial if this relationship now remains unchanged, but the costs will be lower if a normalisation of the labour market moves the Beveridge curve back toward its pre-pandemic position.
The second factor concerns long-term inflation expectations. By various measures, these expectations have been well-anchored through most of the pandemic period, but they have shown hints of increasing during 2022. The costs of containing inflation will be greater if these hints turn into a significant upward trend in expected inflation. It is difficult to predict how expectations will evolve, but we try to shed light on the possibilities by estimating the response of survey measures of expectations to movements in actual inflation.
We simulate paths of future inflation under alternative assumptions about these issues and about the path that the unemployment rate will follow. For the Beveridge curve, we consider both the pessimistic case where the curve stays in its pandemic position and where it shifts back to its pre-pandemic position. For inflation expectations, we estimate how expectations respond to movements in inflation and find that this relation has differed across eras. We consider three cases: expectations revert to their pre-pandemic level, expectations drift as in the pandemic era, and – in the most pessimistic case – expectations drift more as in the pre-anchoring era (before the late 1990s). We focus on the unemployment path forecast by Fed policymakers in their September 2022 Summary of Economic Projections, which peaks at 4.4% in 2023 and 2024. In this case, if we make quite optimistic assumptions about both the Beveridge curve and inflation expectations, the inflation rate falls to a level near the Fed’s target by the end of 2024. For a range of other assumptions, however, inflation stays well above the target (Figure 3).
Figure 3 Scenarios for core CPI inflation conditional on September 2022 Federal Open Market Committee unemployment forecasts (%)
Note: Horizontal dashes show 2.6% target for weighted median CPI based on 2% PCE target as reported on Federal Reserve Bank of Atlanta Underlying Inflation Dashboard. Calculations for core (weighted median CPI) inflation based on unemployment forecast from the Summary of Economic Projections of the Federal Open Market Committee published in September 2022. Vertical line indicates September 2022.
If the Summary of Economic Projections’ unemployment path risks leaving inflation at a high level, how much higher must unemployment rise to more reliably meet the Fed’s inflation goal? We consider two other unemployment paths. One is based on the IMF’s World Economic Outlook of October 2022, where the unemployment rate rises to 5.6% in the second half of 2024. The other is based on Summers’ (2022) suggestion that reversing the rise in inflation will require two years of 7.5% unemployment. As one would expect, higher unemployment lowers inflation. With unemployment peaking at 5.6%, inflation moves to near the Fed’s inflation goal unless inflation expectations become de-anchored. The higher 7.5% unemployment path robustly brings inflation to the Fed’s goal but at the cost of a painful and prolonged increase in unemployment.
Authors’ note: The views expressed in this column are the sole responsibility of the authors and should not be attributed to the International Monetary Fund, its Executive Board, or its management.
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Ball, L, G Gopinath, D Leigh, P Mishra and A Spilimbergo (2021b), “US inflation: Set for take-off?”, VoxEU.org, 7 May.
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