Inflation returns. Revisiting the role of external and domestic shocks with Bayesian structural VAR

Following recent exceptional events in the world economy inflation increased remarkably across most countries, reinvigorating the prevalent discussion on the sources of consumer price dynamics. We analyse this issue for the small open economy of Poland by means of the Bayesian structural VAR. The model describes the evolution of eight key macroeconomic variables and is identified with a set of zero and sign restrictions. This framework, applicable also to other small open economies, provides sound economic interpretation of three domestic and five external shocks, of which two are country-specific and the remaining three are purely global. In a robust manner we show that country-specific energy price and global supply shocks mostly determine the recent inflation surge in Poland. We illustrate that inflation response to these two shocks has become markedly more persistent after the outbreak of the Covid-19 pandemic. We also demonstrate that the choice of an inadequate energy prices proxy may result in the understated importance of the energy price shock, whereas accounting for recent geopolitical threats and other exogenous events does not alter our baseline findings. For policy makers, we show that counterfactual inflation net of external shocks is far lower, but has recently increased as well.