The Dominant Role of Expectations and Broad-Based Supply Shocks in Driving Inflation
The object of this paper is to assess the role of supply shocks, labour market tightness and expectation formation in explaining bouts of inflation. We begin by showing that a quasi-flat Phillips curve, which was popular prior to the pandemic, still fits the post-2020 US data well and that changes in short term inflation expectations likely played an important role in propagating supply shocks in the recent inflation episode. We then document features of the joint dynamics of inflation and inflation expectations to form a baseline for what needs to be explained. Given the difficulty of reproducing these dynamics under rational expectations, we propose and evaluate a model with imperfect information and bounded rationality. In our model, agents see sectoral inflations as being driven by a component common to all the sectors of the economy and by sector-specific shocks. When supply shocks affect many sectors—what we refer to as a broad-based supply shock—agents infer that the common component of inflation has increased, which drive persistent inflation dynamics through their effect of expectations in a quasi self-fulfilling way.