Wednesday, April 12, 2023

Does it matter whether euro zone inflation is supply caused?

 

A brief email exchange with Adam Shapiro made me realize one thing: Whether inflation is supply caused or not makes potentially a lot of difference. Why? Because it could/should influence our thinking about the future inflation outlook insofar as decrease supply might reverse itself eventually.

To see this consider the case of airline ticket prices in euro zone I discussed before. Accepting that the high prices in this segment are demand driven but supply caused, and assuming that airlines will eventually re-learn how to operate as efficiently as before the pandemic, then you would expect prices to decrease significantly without a decline in demand. In other words, this segment would feature deflation in absence of anything else. Including action by the central bank, a quintessential transitory inflation. Hence, the resulting outlook for inflation would be quite optimistic.

On the other hand, if the high prices are solely about demand being too high relative to what was normal during the pandemic, then only decrease in demand will help as supply simply cannot increase that far (at least not in reasonable horizon). In this case prices/inflation will remain high as long as demand is not brought back to its position. Hence, the resulting outlook for inflation is very different: Assuming that there isn’t a recession, inflation will prove sticky, and only through monetary policy demand management will we force it back to target.

Therefore the distinction between driven/caused is important. If it is demand caused, we inflation will be sticky. If it is supply caused then we have hope for inflation to moderate, even if it currently is demand driven inflation.

No comments:

Post a Comment