MONETARY POLICY REPORT | AUTUMN 2022 (box 2)
(authors: Jan Brůha, Jan Šolc, Natálie Tomanová)
Headline inflation started to rise substantially last summer, moving out the tolerance band around the CNB’s 2% target. Both demand factors and cost and other factors contributed to this. Under their price stability mandates, central banks respond mainly to surges in demand pressures. However, they cannot neglect the fight against second-round effects of cost pressures either, especially if the anchoring of long-term inflation expectations is threatened.
In this box, we present the results of two approaches to the decomposition of domestic consumer price inflation into demand and other factors. The first is based on the fact that the labour market plays a crucial role in the identification of demand pressures in the economy. Under this approach, we thus estimate the intensity of demand factors using the LUCI,[1] which expresses the condition of the labour market.[2]
Our analysis of demand-driven inflation based on labour market information reveals that the surge in headline inflation recorded since the start of this year has been driven mainly by costs and other factors (see Chart 1) on the back of a dramatic rise in energy prices. At the same time, it is apparent that demand-driven inflation is also considerably elevated this year. Strong demand since the middle of last year has been mainly affecting the two components of core inflation – prices of goods and market services (see Chart 2). At the start of this year, demand pressures showing up in prices of non-market services and food prices also started to contribute significantly. Until then, they had been relatively moderate. By contrast, demand pressures were not identified in fuel prices.
Chart 1 – Headline inflation this year has primarily reflected costs and other factors, but demand-driven inflation has also been significantly elevated
q-o-q changes in %; seasonally adjusted; source CZSO; CNB calculations
Chart 2 – Demand inflation pressures are apparent in the prices of all the main consumer basket categories (except fuel prices)
q-o-q in %; seasonally adjusted; contributions in pp; source CZSO; CNB calculations
The intensity of the effect of demand factors on inflation decreased a little in 2022 Q3 but remains high from the long-term perspective.[3] At the same time, the reduction in quarter-on-quarter headline inflation in 2022 Q3 was largely a result of a slower increase in inflation driven by costs and other factors (such as a sizeable fuel price correction during the summer holidays). The inflation slowdown originating in demand factors was weaker.
The second approach presented in this box analyses selected core inflation items. It is inspired by a recent analysis by Federal Reserve economist Adam Shapiro, which was subsequently also used at the ECB.[4] Under this approach, inflation is identified as demand-driven if prices move in the same direction as the real quantities of goods and services. Conversely, if prices and quantities move in opposite directions, it is identified as a supply factor. So, with this method it is crucial to link the individual price indices and indices of real sales in retail and services at the level of the consumer price index categories and the corresponding NACE classes.[5]
This analysis, too, suggests that demand factors have had an increased impact on core inflation since the end of last year (see Chart 3). In qualitative terms, this approach offers a similar picture of the intensity of demand factors in inflation as the first one presented above. According to both approaches, demand explains around 50% of the price growth in core inflation. The data for Q3 (only data for July and August are included in this quarter due to the unavailability of data on sales) indicate that demand-driven inflation has eased according to this method as well.
Chart 3 – In the past year, core inflation has been driven by both demand and supply factors; the demand factors weakened this summer
q-o-q in %; seasonally adjusted; contributions in pp; source CZSO; CNB calculations
Note: Ambiguous covers inflation expectations and other factors which cannot be assigned unambiguously to supply or demand.
The significant representation of demand pressures in current inflation shows that the monetary policy tightening cycle started last year was the right step towards achieving price stability. At the same time, it is clear that despite the easing of demand pressures in 2022 Q3, their effect on inflation remains strong – at least from the longer-term perspective.
[1] This regularly published index aggregates information from numerous labour market time series. For details, see the box The extended LUCI in Inflation Report IV/2019.
[2] This approach was described in more detail in the box To what extent are the domestic demand environment and the labour market contributing to the current growth in consumer prices? in MPR – Autumn 2021.
[3] If we abstracted from cost and other factors, the resulting demand-driven inflation would accelerate further year on year, reaching close to 7% in September 2022.
[4] The decomposition of inflation using this method is described in Economic Bulletin Boxes, European Central Bank, vol. 7: The role of demand and supply in underlying inflation – decomposing HICP inflation into components.
[5] There are certain limitations to the methodology used, as the inflation data need to be linked to data on real sales in retail and services. This can be done – with some degree of simplification – for selected core inflation items. The items used in this analysis account for around 90% of core inflation.