Richmond Fed, Report: Detecting Inflation Instability

“We’ve shown that, when inflation was low and stable from 1995 until the pandemic era, there was a systematic relationship between the share of relative price increases and inflation. We then used that relationship to evaluate the stability of inflation during the pandemic. The clear deterioration of that relationship certainly provides cause for concern.”

“However, there are important qualifications and, hence, reasons for hope that inflation may come back to target relatively quickly. First, long-term expectation measures show little sign of inflation becoming unanchored from that target. Second, within the framework presented here, even large deviations from the stable relationship of Figure 2 do not necessarily represent a fundamental unanchoring of inflation (a regime shift). From the standpoint of a typical macroeconomic model, such deviations could arise either from a regime shift or from large shocks in a continued stable environment. In the latter case, as long as monetary policy behaves (or resumes behaving) as it did during the pre-COVID-19 period, inflation will return to target when the shocks dissipate.”

“Ultimately, the proof will need to be in the pudding. However, even absent a rapid return of inflation to target, a reemergence of the pre-pandemic relationship between inflation and the share of relative price increases would be a powerful signal that inflation is behaving in a way consistent with the 2 percent inflation target.”