MACRO: The Dominant Role of Expectations and Broad-Based Supply Shocks in Driving Inflation; Professor Franck Portier (University College London)

Abstract

The goal of this paper is twofold.  We begin by re-examining the relative role of labour market tightness versus inflation expectation in driving inflation in the US, with a particular focus on the last several years. Our explorations points to a Phillips curve has been stable for over 50 years, with inflation almost entirely driven by short run inflation expectations, while labour market tightness plays a very marginal role.  We then explore the determination of short run inflation expectations.  Here we emphasize the role of broad-based supply shocks in driving inflation expectations.  In particular, we provide theory and evidence in support of the notion that  broad-based supply shocks can be easily confused with pure inflation shocks, and this creates a difficult signal extraction problem.   When agents see the prices of many goods increase, they infer that part of the increase reflects pure inflation and this can become self-fulfilling.  In contrast, when inflation is driven by increases in a small number of price changes-- for example large increases in gas prices-- agents are not confused and accordingly, this does not propagate into persistent inflation.  The primary role of monetary policy in such an environment is to convince agents that pure inflation shocks are unlikely.