Mixing it up: Inflation at risk

TL;DR

This paper presents a comprehensive framework to analyze how various economic indicators influence the entire distribution of inflation risks, aiding central banks in understanding and managing inflation during high-risk periods.

Contribution

It introduces a novel framework that decomposes inflation risk drivers across the full forecast distribution and constructs risk measures aligned with central bank preferences.

Findings

U.S. inflation risk was mainly driven by business cycle recovery and commodity prices.

Monetary policy adjustments and credit spreads partially mitigated inflation risks.

The framework provides detailed insights into risk factors affecting inflation.

Abstract

Assessing the contribution of various risk factors to future inflation risks was crucial for guiding monetary policy during the recent high inflation period. However, existing methodologies often provide limited insights by focusing solely on specific percentiles of the forecast distribution. In contrast, this paper introduces a comprehensive framework that examines how economic indicators impact the entire forecast distribution of macroeconomic variables, facilitating the decomposition of the overall risk outlook into its underlying drivers. Additionally, the framework allows for the construction of risk measures that align with central bank preferences, serving as valuable summary statistics. Applied to the recent inflation surge, the framework reveals that U.S. inflation risk was primarily influenced by the recovery of the U.S. business cycle and surging commodity prices, partially mitigated by adjustments in monetary policy and credit spreads.