European Central Bank research reveals inflation "butterfly effect": how limited impacts can trigger a full-scale inflation tsunami.

A study by the European Central Bank (ECB) shows that if a relatively limited price shock hits a closely connected network of enterprises, it may trigger a large-scale inflation wave. ECB economists Anton Nakov and Barcelona International Economic Research Center researcher Michel Gaspar wrote on Tuesday that this is because shocks create chain reactions along the supply chain, with one company's output cost being another company's input cost. They pointed out, "When the shock is significant, these cascading effects can disproportionately magnify. A major shock, such as a sharp drop in productivity or sustained global commodity price surge, may trigger a wave that impacts the entire economy." These findings help explain why the inflation rate in the eurozone briefly rose above 10% after the Russia-Ukraine conflict led to a surge in energy costs. ECB officials underestimated the impact on consumer prices at the time and now acknowledge that their response was too slow. Three years after the Russia-Ukraine conflict erupted, the inflation rate and the ECB's key interest rates have fallen back to 2% - economists are studying how to prevent similar misjudgments in the future. Nakov and Gaspar found that standard macroeconomic models have difficulty explaining the observed surge in inflation since 2022, as well as the frequency of price adjustments by businesses. Therefore, they constructed a "detailed economic model" containing nearly 40 sectors, interconnected by realistic input-output relationships. The model replicated the surge in prices and the abnormally fast speed of price adjustments. The study concludes, "The post-pandemic surge in inflation is not driven by greedy companies or overly expansionary monetary policy, but by unexpected price shocks transmitted through closely connected production networks. Close attention to these transmission mechanisms is crucial for understanding future inflation risks and designing effective policy responses." Their research also provides insights into demand-driven rather than supply-driven price increases. Researchers found that in such cases, production networks slow down the adjustment speed, "which means that monetary policy easing or tightening can stimulate or suppress the economy without necessarily causing excessive inflation or deflation."