A Framework Explaining Inflation Surprises

Abstract

Four major inflation surprises mark the modern economic era: diminished response of inflation to stimulus since the 1990’s, increasing financial bubble cycles, resilience of inflation during the Great Financial Crisis, and, of course, the pandemic inflation. To explain these surprises, this paper presents a new framework for analysing inflation as driven by three major components: a Natural Rate of Inflation reflecting an economy’s dynamism, monetary inflation driven by the relative unit value of a currency as determined by monetary aggregates, and cyclical inflation governed by fiscal policy and influenced by trade balances and demand shifts.

Monetary inflation becomes increasingly less responsive to stimulus (inelastic) at a geometric rate, explaining both the 1990’s decline and increased financial bubbles. Another consequence was incomes falling behind growth in money, credit, and asset prices. Natural Inflation sets a floor on the overall inflation rate, which was evident following the GFC. The inflationary effect of unprecedented U.S. pandemic deficits is most evident when viewed in conjunction with the monetary model and accounts for the timing and magnitude of the pandemic inflation. The analysis indicates significant differences in the effects of fiscal and monetary stimulus, a return to sub-2% inflation, and that central banks are neither responsible for nor able to offset the inflation surprises.