MONETARY POLICY REPORT | AUTUMN 2021 (box 2)
(authors: Jan Brůha, Jan Šolc, Natálie Tomanová)
Domestic inflation rose dramatically at the end of the summer, reaching its highest levels in more than a decade. Besides the often discussed cost effects (mostly from abroad), a strongly inflationary domestic environment is contributing greatly to the current rapid growth in consumer prices. The coronavirus pandemic dampened consumer appetite and cooled the labour market only temporarily and to a limited extent. In addition, this happened in the context of a significant easing of fiscal, monetary and macroprudential policy. This box analyses the extent to which domestic demand factors are contributing to the current strong growth in prices.
The labour market is playing an important role in the domestic inflation pressures, which are closely linked to the overall demand environment. The Labour Utilisation Composite Index (LUCI)[1] was thus used to estimate the inflation pressures in the domestic economy. The correlation of the categories of items in the consumer basket[2] with the LUCI was calculated based on the data for 2005–2021. This correlation, indicating the effect of the domestic economy and demand environment on inflation in each category, ranges from significantly positive to slightly negative (see Chart 1). This means that the consumer basket contains goods whose inflation has a significant cyclical demand character, while for other categories the impact of the demand environment is negligible.
Chart 1 – The sharp rise in energy prices was particularly significant for consumer basket items strongly correlated with the LUCI
x-axis: correlation; y-axis: annualised q-o-q price growth in % in 2021 Q3; colour of bubble corresponds to inclusion in analytical group; size of bubble corresponds to weight of category
The growth in prices this summer was particularly strong for items whose inflation is significantly positively correlated with the LUCI, which includes the recently rapidly growing contribution of imputed rent. This points to a significant role of the domestic demand environment in the current inflation episode and not to the dominance of external cost factors.
The categories of the consumer basket were first divided into five routinely monitored analytical groups (food, fuels, goods, market services and non-market services). Based on their positive correlations with the LUCI, the share of demand factors in inflation in each category in 2021 Q3 was then estimated. Demand factors had the strongest impact on growth in market services prices, with demand explaining more than 70% of the price rise (see Chart 2). In other categories – non-market services, goods and food – strong demand caused about one-third of the price growth during this period; in the case of fuel prices, the effect of the domestic demand environment and the labour market was negligible, in line with intuition. Compared with market services, the above categories were affected much more strongly by cost and similar factors. Overall, the domestic demand environment and the labour market accounted for almost half of the rise in consumer prices this summer according to the empirical results. This indicates that the current inflation episode has a significant demand element.
Chart 2 – The demand environment and labour market situation are affecting services price inflation most strongly
estimated share of demand environment on quarterly consumer price inflation in % in 2021 Q3
An alternative measure of core inflation called “supercycle” inflation[3] was constructed on the basis of the correlation with the LUCI. In its calculation, the initial statistical weights of the consumer basket categories are re-weighted according to their sensitivity to changes in the demand environment: items positively correlated with the LUCI have a higher weight, the higher is their correlation with the LUCI, while items with zero or negative correlation have zero weight. The resulting “supercycle” inflation index yields information on cyclical (demand-conditional) inflation. Such inflation cannot be expected to fade quickly, as may be the case for inflation caused by external cost factors. After the financial crisis, “supercycle” inflation in the Czech Republic was below headline inflation for quite a long time (see Chart 3). This indicates that inflation was driven mostly by cost factors at the time (especially in 2012). After they diminished rapidly, the Czech economy experienced a long period of very low inflation consistent with the cyclical downturn and high unemployment rate. Several years later, by contrast, a labour market recovery combined with strong wage growth led to a rise in demand. This was reflected in an increase in “supercycle” inflation, which has stayed above headline inflation ever since. The coronavirus pandemic partly dampened demand and cooled the labour market. The lifting of anti-epidemic restrictions this summer and the related recovery in economic activity and the labour market have led to renewed consumer appetite and related upward pressure on prices.
Chart 3 – Demand-pull inflation is documented by “supercycle” inflation, which is currently higher than the usually followed headline inflation
q-o-q growth rates in %; annualised
In addition to sizeable cost pressures, the current rapid growth in consumer prices thus reflects a strong effect of the domestic demand environment and labour market, both of which are reflected in household consumption. These factors accounted for almost half of the inflation recorded during the summer. “Supercycle” inflation, based on an alternative calculation of consumer basket weights, also indicates strong demand-driven (cyclical) inflation. The latter plays an important role in monetary policy decision-making.
[1] This regularly published index aggregates information from numerous labour market time series. For details, see the box in IR IV/2019.
[2] The analysis involved 105 categories of goods and services together covering the entire consumer basket.
[3] “Supercycle inflation” is similar to the supercore inflation measure tracked by the European Central Bank. For details, see https://www.ecb.europa.eu/pub/economic-bulletin/articles/2018/html/ecb.ebart201804_03.en.html#toc5.