A recent study presented at the Brookings Papers on Economic Activity (BPEA) conference on September 25 indicates that unexpectedly strong demand for goods and services played a more significant role in driving inflation post-COVID-19 than supply chain disruptions. The study, authored by Domenico Giannone from Johns Hopkins University and Giorgio E. Primiceri from Northwestern University, utilized economic models to analyze consumer price inflation in the United States and the euro area during and after the pandemic.
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Inflation remained low throughout 2020 as both supply and demand were affected by the pandemic. However, the authors observe that inflation in the U.S. began to rise in early 2021, peaking in the second quarter of 2022 and subsequently declining. Inflation in the euro area followed a similar trend, albeit with about a six-month delay.
The study identifies three primary factors contributing to the unusual demand: a significant rebound in spending following the easing of pandemic restrictions, expansionary government spending financed by deficits, and low interest rates maintained by accommodative monetary policy. The authors assert that both economic forecasters and policymakers underestimated the strength of this recovery and the persistence of inflation, a situation consistent with demand exceeding expectations.
While the findings might contrast with the emphasis on supply chain issues and energy market disruptions, the authors acknowledge that these supply shocks also had an impact. However, they argue that accommodative monetary policy mitigated these effects, leading to higher inflation as a consequence of supporting economic recovery.
The authors do not take a definitive stance on whether the trade-off of higher inflation for economic recovery was beneficial. They suggest that policymakers may have responded to an economic outlook that appeared weaker than reality, based on initial GDP releases.
Primiceri, speaking with the Brookings Institution, emphasized that central banks’ ability to overlook temporary supply shocks hinges on their credibility, which is influenced by their historical responses to inflation. He cautioned that treating such shocks as transitory without sufficient caution could undermine their temporary nature, as observed during the pandemic.