Understanding Euro Area Inflation Dynamics Why So Low For So Long

Despite closing output gaps and tightening labor markets, inflation has remained low in the euro area. Based on an augmented Phillips Curve framework, we find that this phenomenon—sometimes attributed to low global inflation—has been primarily caused by a remarkable persistence of inflation, keeping it low despite the reduction in slack. This feature is shown to be specific to the euro area (in comparison with the United States). Monetary policy needs to stay accommodative to help guide inflation back to target.

After 2012, inflation has been unexpectedly low across much of the developed world and economists speak of a “missing inflation” puzzle, namely inflation was expected to be higher on the back of an ongoing recovery. This paper investigates the causes and consequences of low inflation in the euro area after 2012 and analyses whether monetary policy has been successful in dampening the risks associated to low inflation. The paper finds that the missing inflation was primarily due to cyclical factors - domestic in the earlier part of the period and global in the latter part - and that the Phillips curve remains a useful tool in understanding inflation dynamics over the period of interest. The succession of negative shocks constrained headline inflation for a prolonged period, and there is evidence of an increase in the persistence of inflation and a fall in the trend inflation rate, which had begun to have a greater influence on longer-term inflation expectations. This may have signaled uncertainty over the effectiveness of unconventional monetary policy measures, but public belief in the ECB's commitment to keep the annual rate of HICP inflation below but close to 2% has remained intact. The paper concludes that unconventional monetary policy measures are effective in mitigating the downside risks to price stability, curtailing risks of de-anchoring, and expanding aggregate demand.

Despite closing output gaps and tightening labor markets, inflation has remained low in the euro area. Based on an augmented Phillips Curve framework, we find that this phenomenon—sometimes attributed to low global inflation—has been primarily caused by a remarkable persistence of inflation, keeping it low despite the reduction in slack. This feature is shown to be specific to the euro area (in comparison with the United States). Monetary policy needs to stay accommodative to help guide inflation back to target.

We provide evidence on the fit of the New Phillips Curve (NPQ for the Euro area over the period 1970-1998, and use it as a tool to compare the characteristics of European inflation dynamics with those observed in the U.S. We also analyze the factors underlying inflation inertia by examining the cyclical behavior of marginal costs, as well as that of its two main components, namely, labor productivity and real wages. Some of the findings can be summarized as follows: (a) the NPC fits Euro area data very well, possibly better than U.S. data, (b) the degree of price stickiness implied by the estimates is substantial, but in line with survey evidence and U.S. estimates, (c) inflation dynamics in the Euro area appear to have a stronger forward- looking component (i.e., less inertia) than in the U.S., (d) labor market frictions, as manifested in the behavior of the wage markup, appear to have played a key role in shaping the behavior of marginal costs and, consequently, inflation in Europe.

After 2012, inflation has been unexpectedly low across much of the developed world and economists speak of a "missing inflation" puzzle, namely inflation was expected to be higher on the back of an ongoing recovery. This paper investigates the causes and consequences of low inflation in the euro area after 2012 and analyses whether monetary policy has been successful in dampening the risks associated to low inflation. The paper finds that the missing inflation was primarily due to cyclical factors - domestic in the earlier part of the period and global in the latter part - and that the Phillips curve remains a useful tool in understanding inflation dynamics over the period of interest. The succession of negative shocks constrained headline inflation for a prolonged period, and there is evidence of an increase in the persistence of inflation and a fall in the trend inflation rate, which had begun to have a greater influence on longer-term inflation expectations. This may have signalled uncertainty over the effectiveness of unconventional monetary policy measures, but public belief in the ECB's commitment to keep the annual rate of HICP inflation below but close to 2% has remained intact. The paper concludes that unconventional monetary policy measures are effective in mitigating the downside risks to price stability, curtailing risks of de-anchoring, and expanding aggregate demand.

Do euro area inflation expectations remain well-anchored? This paper finds that the protracted period of low (and below-target) inflation in the euro area since 2013 has weakened their anchoring. Testing their sensitivity to inflation and macroeconomic news, this paper expands existing results in two key dimensions. First, by analyzing all available (advanced) inflation releases. Second, the reactions of expectations are investigated at daily, time-varying and intraday frequency regressions to add robustness to our conclusions. Results point to a significant impact of inflation news over recent years that had not been observed before in the euro area.

"Why has euro area (core) inflation not fallen further during and after the "great recession"? How different are inflation dynamics across Member States? This paper analyses core inflation dynamics in the euro area and its Member States using a hybrid specification of the Phillips curve. Inflation expectations are directly observed from an expert survey, so no assumptions need to be imposed about expectations formation. The choice of the hybrid Phillips curve framework is vindicated, as the data clearly indicate the relevance of both backward-looking inflation and inflation expectations. The impact of the output gap on core inflation is significant but not large. The combination of stable inflation expectations, sluggish price adjustment and an only moderate impact of the output gap on inflation helps understanding the stability of core inflation despite large and persistent output gaps in the aftermath of the crisis. Although the heterogeneity of Phillips curve relationships across Member States is not large, the exceptionally large output gap caused by the crisis is one driver (among others) of the recently observed inflation differentials in the euro area"--Publication information p.

The surge in inflation rates experienced by the euro area since the beginning of 2021 is rooted in supply shocks that have led to bottlenecks and an energy crisis. This paper shows that the shifts of inflation expectations into prices could cause some persistence in the excessive inflation process. In this last respect, the flatness of the Phillips curve implies that the unemployment-inflation sacrifice ratio is high; hence, there are substantial costs of bringing inflation down through a contraction in aggregate demand. However, a restrictive monetary policy stance appears unavoidable to keep inflation expectations anchored. A compelling policy mix can overcome this trade-off by supporting a favourable scenario with a soft landing of the economy and an inflation rate returning to target at the medium-long horizon. This paper was provided by the Economic Governance and EMU Scrutiny Unit (EGOV) at the request of the Committee on Economic and Monetary Affairs (ECON) ahead of the Monetary Dialogue with the ECB President on 20 March 2022.

This paper analyzes euro area and U.S. inflation dynamics since the beginning of the 1990s by estimating New Keynesian hybrid Phillips curves with time-varying parameters. We measure inflation expectations by subjective forecasts from Consensus Economics survey and so do not assume rational expectations. Both rolling regressions and state-space models are employed. The results indicate that in both economic areas the inflation dynamics have steadily become more forward-looking over time. We also provide evidence that the impact of the output gap on inflation has increased in recent years. Overall, diminished inflation persistence emphasizes the role of credible monetary policy in inflation dynamics.