Title: Financial shocks and inflation dynamics
Authors: Sandra Eickmeier - Deutsche Bundesbank (Germany)
Angela Abbate - Deutsche Bundesbank (Germany)
Esteban Prieto - Deutsche Bundesbank (Germany) [presenting]
Abstract: The aim is to assess the effects of financial shocks on inflation, and to what extent financial shocks can account for the ``missing disinflation'' during the Great Recession. We apply a vector autoregressive model to US macro and financial data over 1988-2015 and identify financial shocks through sign restrictions. Our main findings are as follows. Expansionary financial shocks temporarily lower inflation, i.e. they are disinflationary. This result withstands a large battery of robustness checks. Moreover negative financial shocks may have helped preventing a deflation during the crisis. We then explore the transmission channels of financial shocks relevant for inflation and found that effectiveness of the cost channel can explain the inflation response, a finding which could guide future theoretical work. Policy implications are twofold. First, financial shocks which raise output and, at the same time, lower inflation bring about an additional trade-off for a central bank which stabilizes output and prices. Second, a monetary policy which aims at stimulating credit supply and lowering funding costs risks pushing inflation down, something that should be avoided in a low inflation environment.