ECB Study Finds ‘Pricing Cascades’ Can Cause Inflationary Wave

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(Bloomberg) — A relatively contained price shock can trigger a massive inflationary episode if it hits a closely connected network of firms, according to research by the European Central Bank.

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That’s because of the chain reactions rippling through supply lines, where one firm’s output charges are another’s input costs, ECB economist Anton Nakov and Mishel Ghassibe, who works at the Center for Research in International Economics in Barcelona, wrote in an article published Tuesday on the ECB’s website.

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“These cascades grow disproportionately when the shock is large,” they said. “A major disruption — such as a large fall in productivity or a sustained jump in global commodity prices — can set off a wave that washes over much of the economy.”

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The findings help explain why euro-area inflation climbed above 10% after Russia’s invasion of Ukraine sent energy costs surging. ECB officials underestimated the implications for consumer prices and admit now that they were late to respond.

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Three years after the attack, inflation and the ECB’s key interest rate are back at 2% — and economists are studying how similar mistakes can be avoided in the future.

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Nakov and Ghassibe found that standard macroeconomic models struggle to explain both the surge in inflation observed since 2022 and the frequency at which businesses changed their pricing.

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So they built a “detailed representation” of the economy with almost 40 sectors linked through realistic input-output relationships that reproduced both the jump in prices and the unusually rapid rate of adjustments.

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“The post-pandemic inflation surge was not driven by greedy firms or overly expansionary monetary policy, but by unexpected price shocks cascading through a tightly connected production network,” Nakov and Ghassibe concluded. “Paying close attention to these mechanisms is essential for understanding future inflation risks and designing effective policy response.”

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Their research also contains a lesson for when price gains are driven by demand, rather than supply.

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Networks slow down adjustments in such cases, “which implies that monetary loosening or tightening can stimulate or restrain the economy without necessarily generating excessive inflation or deflation,” the researchers found.

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