Aggregate demand

• The coronavirus (COVID-19) pandemic had a severe and extraordinary impact on the global economy during the first half of 2020.
• Economic activity across advanced economies was severely affected, and consumer price inflation declined on the back of these developments.
• The pandemic weighed on not only headline inflation but also underlying inflation measures, such as consumer price inflation excluding food and energy, which declined during the initial lockdowns and gradually rebounded thereafter.
• This pattern was shaped by the confluence of two key forces triggered by the crisis: weak demand and constrained supply.
• This box uses granular data on consumer spending and prices, together with a structural analysis using Bayesian Vector Autoregression (BVAR) models, to study their relative impact on inflation in key advanced economies outside the euro area.
• [1] Understanding the relative impact of demand and supply shocks in the pandemic is crucial for gauging the inflation outlook.

Chart A

Global sectoral output and prices: a survey data perspective (x-axis: output; y-axis: output price; PMI, diffusion indices, quarterly averages)
• Demand-sensitive components of the consumption basket largely account for declining core inflation during the initial lockdowns.
• Following Shapiro,[3] we study the sensitivity of consumer basket components to disruptions caused by the pandemic.
• [4] For the United States, more than 60% of personal consumption expenditures show some degree of sensitivity, while the equivalent share in the United Kingdom is around 40%.
• For both countries, the demand-sensitive components account for a large proportion of the initial decline in consumer price inflation during the first lockdowns, as well as for its gradual increase observed during the third quarter (see Chart B).

Chart B

Source: ECB calculations based on Shapiro.Notes: The framework relies on a two-equation, seemingly unrelated univariate regression of prices and quantities.
• We estimate a structural BVAR model for the United States, United Kingdom and Japan and find that during the second quarter of 2020, demand shocks contributed around twice as much to the decline in output as supply shocks (Chart C, panel (a)).
• [5] The recovery in the third quarter of 2020 was driven by both demand and supply factors in broadly similar proportions.
• Turning to nominal developments, the impact of weak demand on inflation dominated in the second quarter of 2020, as it was only partly outweighed by supply constraints.
• During the initial recovery, demand strengthened and pushed up inflation, which was also supported by some unwinding of the supply constraints (Chart C, panel (b)).
• While pent-up demand may support the recovery and push up inflation, supply constraints could unwind quickly, which would create disinflationary pressures.
• [7] These findings argue against approaches that use aggregate data and may erroneously classify such sectoral supply shocks as aggregate demand shocks.

Chart C

Historical decomposition of gross domestic product (GDP) and consumer price inflation (CPI) (quarterly percentage changes, percentage points)