Inflation is hard to control, and it is even harder to pin down the cause of a specific surge. The burst of inflation that followed the COVID-19 pandemic surprised many observers, including policymakers and the media, and prompted calls for policies to slow the pace of increase in prices.
Many people believed that the increase in prices was caused by supply chain shortages. The theory was that as demand grew while production capacity remained constrained, firms increased prices to capture higher profit margins. This led to a vicious circle in which higher prices led to more demand, requiring even greater price increases and so on.
But was this explanation correct? Our research indicates that the most significant driver of the 2021-2022 inflation shock was not supply chain constraints. Instead, it was the rapid expansion of profit margins. The margins expansion was driven by a combination of factors, including the shock to firms from bare shelves early in the pandemic, higher energy prices, and backlogs of work orders that resulted from factory closures.
We also find that differences in labor market slack account for a substantial part of the cross-country variation in the timing of core inflation acceleration. We conclude that these findings suggest that the recent inflation surge was much more severe and longer lasting than existing studies of previous episodes have flagged, and that the pace of disinflation will be significantly faster going forward. In a future Economic Brief, we will discuss how to better understand these dynamics.
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