How Much Do Supply and Demand Drive Inflation?
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Inflation has remained at levels well above the Federal Reserve’s inflation goal of 2% for over a year. Separating the underlying data from the personal consumption expenditures price index into supply- versus demand-driven categories reveals that supply factors explain about half of the run-up in current inflation levels. Demand factors are responsible for about one-third, with the remainder resulting from ambiguous factors. While supply disruptions are widely expected to ease this year, this outcome is highly uncertain.
Inflation declined rapidly at the onset of the pandemic in the spring of 2020 before taking a dramatic turn upward in early 2021, rising to levels that remain well above the Federal Reserve’s longer-run goal of 2% on average. Researchers and policymakers have pointed to both supply and demand factors as being responsible for elevated inflation. For instance, Barnichon and Shapiro (2022) showed the impact of supply-related factors such as labor shortages, while Barnichon, Oliveira, and Shapiro (2021) and Jordà et al. (2022) demonstrated the importance of heightened demand stemming from pandemic-related fiscal relief. The extent to which either supply or demand factors are responsible for higher inflation levels has important implications for monetary policy. As Fed Chair Powell stated in a recent interview, “What [the Fed] can control is demand, we can’t really affect supply with our policies…so the question whether we can execute a soft landing or not, it may actually depend on factors that we don’t control” (Marketplace 2022).
In this Economic Letter, I quantify and track the impact of supply- and demand-related factors on personal consumption expenditures (PCE) inflation. Similar to the methodology introduced in Mahedy and Shapiro (2017), and outlined in Shapiro (2022), I assess inflation rates by spending category. I divide categories in the PCE basket into supply- and demand-driven groups. Demand-driven categories are identified as those where an unexpected change in price moves in the same direction as the unexpected change in quantity in a given month; supply-driven categories are identified as those where unexpected changes in price and quantity move in opposite directions. This methodology accounts for the evolving impact of supply- versus demand-driven factors on inflation from month to month. To help monitor these changes, the San Francisco Fed has launched a new Supply- and Demand-Driven PCE Inflation data page with monthly data updates.
