On the Detection of Structural Breaks: The Case of the Covid Shock

Abstract

Both the Federal Reserve (Fed) and the European Central Bank (ECB) have been criticized for not having perceived that the outbreak of Covid at the beginning of 2020 would lead to a structural change in inflation in the early 2020s. Both central banks viewed the initial inflation surge in 2021 as temporary and delayed monetary tightening until 2022. We argue that the existing literature on structural breaks could not have been useful to policymakers because it identifies the breaks in an arbitrary way. The tests used to identify breaks do not incorporate prior knowledge that a break may have occurred so that the tests have very little power to detect a break that occurs at the end of the sample. We show that, in the event of a major shock, such as Covid, using knowledge that a break may have occurred and testing for a break in a recursive way as new data become available could have alerted policymakers to the break in inflation. We conduct Monte Carlo simulations suggesting that our method would have identified that a break had occurred in inflation by the end of 2020, well before policymakers had perceived the break.