Today, we are pleased to introduce to you the Kevin Palala, Luke Rossi, Massimiliano Sfregora and Fabrizio Venditi Bank of Italy. The views expressed in this note are solely those of the author and do not necessarily reflect those of the Bank of Italy.
Inflation has declined in both the US and the Euro Area (EA) since around mid-2022. But the rate of decline has not been as rapid as initially expected. Professional forecasters have continued to upgrade their inflation forecasts even as energy prices have fallen sharply, more than futures prices predicted a year ago. This trend is particularly evident in the Euro Area (EA), as shown in Figures 1 and 2. Unexpected increases in core inflation, particularly in non-energy industrial goods and services, were the main catalyst behind these unexpected increases in inflation.[1]
This raises the question of whether the surprisingly high core inflation in these economies is the result of a delayed pass-through of energy prices in the past, and what to expect going forward given the sharp decline in energy prices since mid-2022. The analysis summarized in this column concludes that, for the United States, energy prices accounted for a negligible share of the rise in core inflation over the past two years. This is not the case in the euro area, where the pass-through has been substantial and continuing.
The pass-through of energy prices to core inflation can be measured in terms of how core prices respond to unexpected changes in energy prices In the context of vector autoregressive models. We first estimate such a model using data up to 2020 (thus excluding 2021-2022 energy price shocks), and then extend the sample to the last available data point for 2023.Benchmarks include consumer energy inflation, food inflation, core inflation[2]unemployment rate and negotiated wage growth.[3]
Using data up to 2020, a sample before the most recent energy price shock, A 10% rise in consumer energy prices led to a relatively modest rise in core inflation in the US and the Euro Area (EA)about 0.1% to 0.2%, as shown in the gray shaded area in Figure 3. However, when the analysis is extended to 2023 data, which includes energy price shocks in 2021-2022, the core inflation response to changes in energy prices rises significantly in EA (shown as the purple shaded area in Figure 3). This suggests that the surge in energy prices has led to a shift in the relationship between core prices and energy input costs. Indeed, after a 10% energy price shock, the largest impact of an energy price shock on core inflation in Europe is estimated at 0.8% (a quadruple increase) and 0.4% in the US (a mere triple increase).
finer analysis – See Figure 4 – Reveals that the main reason for the sharp rise in EA core inflation sensitivity to energy prices is the stronger sensitivity of core inflation to gas and electricity price shocks. Our conjecture is that large shocks to these costs lead to non-linear adjustments in final prices. This likely reflects shocks of unprecedented size and duration in EA. The shock to energy prices in the European region is indeed historic. For example, from early January 2021 to a peak in summer 2022, spot gas prices in the European region increased roughly 17-fold (based on TTF prices; while US spot gas prices rose 3.8-fold, according to Henry Center prices). These proportional shocks may induce some nonlinearities in the transmission chain in the EA.
For example, this interpretation is consistent with a pricing model in which firms face fixed price adjustment costs. Cavallo et al. (2023) show that indeed “large shocks propagate fast” in a general model with menu costs.[4] Faced with a shock to production costs, businesses need to decide whether to adjust their best prices and cover menu costs, or keep prices constant at the expense of lower profits. The larger the shock, the less attractive the latter option is, and thus the further the actual price will be from the profit-maximizing price.[5]
The analysis draws two conclusions. First, core inflation in the US is unlikely to benefit from normalizing energy prices. U.S. core inflation is currently being driven by continued increases in housing prices and the prices of items such as clothing, furniture and some non-housing services. It will take time, and possibly some slack in the labor market, for these prices to start falling consistently. Second, in economic zones, core prices are likely to decelerate due to lower energy prices. In East Asia, prices of goods and services remain affected by past energy price shocks. As these prices start to fall, they should contribute meaningfully to cooling core prices.
[1] The US core inflation forecast for the final quarter of 2023, based on the SPF, rose from 2.9% to 3.4% between the second quarter of 2022 and the first quarter of 2023. For EA, the SPF core inflation forecast was revised from 2.3% to 4.4% over the same period.
[2] Consumer prices are measured against HICP for the European region and CPI for the US. For the US, we consider core inflation measures excluding the “housing” component. This component accounts for a disproportionate share (about 40%) of US core inflation and is completely insensitive to energy prices. As such, this would severely reduce the sensitivity of US core prices to energy prices and distort comparisons with EA. Core inflation, which excludes housing, also figures prominently in the U.S. monetary policy debate, with Fed officials, notably FOMC Chairman Jerome Powell, often calling it “the most important category for understanding the future evolution of core inflation.”See “Inflation and the Labor Market,” by Jerome H. Powell, Nov. 30, 2023, available at here.
[3] Energy shocks are identified by assuming (as a criterion in this paper) that all variables in the system may respond to energy shocks simultaneously, but consumer energy prices respond to other shocks only with a lag.
[4] Cavallo A., F. Lippi F. and Miyahara K. (2023), “Inflation and Mismatches in New Keynesian Models”, ECB Central Banking Forum, Sintra, 27 June.
[5] See also Nakamura, E. and J. Steinsson, “Five Facts About Prices: A Reassessment of the Menu Cost Model”, Quarterly Journal of Economics, 123 (2008), 1415–1464 and J. Vavra “Inflation Dynamics” and Time-Varying Volatility,” Quarterly Journal of Economics, 129 (2014), 215-258.
this article was written Kevin Perrara, Luca Rossi, Massimiliano Sfregola and Fabrizio Venditi.
