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 induced by supply shocks likely played a major role in the recent inflation episode. We then document features of the joint dynamics of inflation and inflation expectations. 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. We show that departure from full rationality is minor, but that it is enough for broad-based supply shocks to be amplified and propagated over time in a manner needed to explain the data