## sipea2023044 - Sections 1–2

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---

### A. Stylized Facts
- Before the recent energy crisis, headline and core inflation in Portugal "hovered below 2 percent" for most of the last decade.
- Core inflation is defined as headline inflation excluding energy and unprocessed food prices.
- Portugal’s inflation has been strongly correlated with the euro area (EA), but often below the EA level since 2010, driven mostly by non-energy industrial goods such as clothing and footwear.
- Tourism-related prices fell by "almost 10 percent" during the Covid pandemic, contributing to Portugal’s inflation moving further below the EA level.
- HICP composition and weights:
  - Weight of food and non-alcoholic beverages has been "above the EA level since 2012 (at over 20 percent)".
  - Weight of housing, water, electricity, and gas is "10 percent" in Portugal versus "16 percent" for the EA.
  - Imputing average EA weights to Portugal would raise Portugal’s inflation by only "about 0.2 pp" above its actual level in 2021 and 2022.
- Passthrough dynamics in 2022:
  - Energy price passthrough to Portugal was "about 9 percent increase y/y" in March 2022 versus "about 47 percent for EA".
  - Policy measures (reduction in network access tariffs, tax exemptions on fuel excises and VAT, Iberian price cap announced mid-2022 and effective in H2) muted energy passthrough.
  - Headline inflation peaked in "October 2022 (10.6 percent y/y)" and then trended downward.
  - Core inflation exceeded EA level in early 2022 and "has hovered around 8 percent since September 2022".
- Consumer price expectations:
  - Mirrored headline inflation trends, picked up from early 2021, exceeded EA averages by end-2022, and began declining during 2022H2.

### B. Drivers of Inflation — The Phillips Curve
- Empirical approach and data:
  - Estimated a standard Phillips curve relating inflation to past and expected inflation, slack, energy and food prices (in domestic currency, weighted by HICP shares), and other external price pressure (weighted import producers' prices).
  - Lags for external price pressures and food prices included to allow longer passthrough.
  - Estimation sample: "2000: Q1 to 2022: Q4" for 27 advanced economies (including PRT).
- Key estimation outcomes and comparative facts:
  - Relationship between slack (unemployment gap) and headline and core inflation is negative and significant for both Portugal and other advanced economies (AE), and of similar magnitude.
  - Backward- and forward-looking inflation expectations play comparable roles in Portugal and AE countries.
  - Passthrough coefficients for food prices and external price pressure are positive but smaller for Portugal than for the AE group.
- Contributions to Portugal’s 2022 inflation (headline):
  - The Phillips curve model explains "about ¾" of Portugal’s inflation in 2022 (model performs slightly better for Portugal than for the AE group, where it explained at most "60 percent").
  - Food prices: "about 3.5 pp".
  - External price pressures: "about 2.5 pp" (larger for Portugal than for AE).
  - Energy prices: contribution estimated to be below the AE average (reflecting domestic energy price policies and lower HICP energy weight).
  - Unemployment gap: only a small impact for AE and "almost no impact for Portugal".
  - Inflation expectations: despite rising since 2021, they remained anchored and "have driven inflation in the opposite direction than the remaining factors since 2022H2".
- Unexplained residual in 2022 — potential drivers:
  - Non-linear effects of exceptionally large commodity price changes and possible alteration of the inflation process after the pandemic and Russia’s war in Ukraine.
  - Indicators may not fully capture spillovers between inflation components after the pandemic.
  - Country-specific contributors in Portugal:
    - Labor market tightness: unemployment rate remains below pre-pandemic level and below estimated equilibrium; job vacancies per unemployed and firms reporting labor shortages have risen.
    - Administered prices and policy measures: Iberian cap estimated to have reduced electricity prices by "about 16 percent".
    - Wage growth: compensation of employees grew generally above the EA average since 2017; in 2022 nominal wages increased "6.1 percent" versus headline inflation "8.1 percent" in 2022; real wages rose in 2022H1 and fell in 2022H2.
    - Tourism: pickup in tourism-related prices (e.g., hotels and restaurants) of "13 percent" in Portugal versus "7 percent" for the EA average.

### C. Inflation Projections
- Model-based baseline:
  - The Phillips curve model predicts headline and core inflation in Portugal and AE countries to decline to "about 2 percent by the end of 2024", driven by larger slack, lower energy prices, and lower external price pressures.
  - In the short run, falling commodity prices mainly reduce headline inflation; core inflation declines only through second-round effects with some lag.
- Staff and national projections:
  - Staff baseline (March 2023 WEO assumptions) expects headline and core inflation to decline more gradually, "reaching the 2 percent target only after 2025" (accounts for factors not captured by the model such as minimum wage growth and labor market tightness).
  - Banco de Portugal (March 2023) projects slower convergence, "reaching 2 percent in the course of 2025".
- Risk assessment and scenario simulations:
  - Model uncertainty: if 2022 forecast errors fade only slowly, the model may underestimate near-term inflation.
  - Key simulation outcomes:
    - A change in the unemployment gap by "2 pp" (decrease/increase) would raise/lower headline and core inflation by "about 0.5 pp over next four quarters".
    - A temporary de-anchoring of inflation expectations higher by "1 pp" would elevate headline and core inflation "temporarily by some 1 p p over the next 4 quarters".
    - A "20 percent" higher/lower energy and food price shock would increase headline inflation by "1 to 2 pp" and increase core inflation by "less than 1 percent".
    - If the inflation formation becomes more backward-looking (increasing the coefficient on past inflation in the Phillips curve to "0.8" — level observed pre-1990), headline inflation would increase by "about 2 pp" and core by "about 1 pp", with effects dampening over time as long as inflation expectations remain anchored.

### D. Is There a Risk of a Wage-Inflation Spiral?
- Literature evidence:
  - Recent studies suggest the risk of sustained wage-price spirals is present but "contained so far" in advanced economies.
  - Wage dynamics in AEs are mostly driven by labor market conditions and inflation expectations, not past inflation.
  - Historical analysis of 79 wage-price spiral episodes identified 29 episodes similar to the ongoing episode; these typically did not produce sustained wage-price spirals.
  - Baba and Lee (2022): in response to a "10 percent" oil price shock, wages typically increase by "0.3 percent over three years" and then stabilize.

### E. Conclusions (select highlights)
- Portugal’s recent inflation surge was largely driven by food and external price pressures; energy contributed less than in many EA peers due to policy measures and lower HICP energy weight.
- The estimated Phillips curve explains "about ¾" of Portugal’s inflation in 2022 but leaves an unexplained residual that may reflect nonlinear passthrough, post-pandemic structural shifts, labor market tightness, administered price dynamics, wage developments, and tourism price dynamics.
- Under baseline assumptions, inflation is projected to decline toward "about 2 percent by the end of 2024" in the model, while staff and Banco de Portugal projections expect slower convergence ("after 2025" and "in the course of 2025", respectively).
- Risks to faster disinflation include de-anchoring of expectations, tighter labor markets prompting higher wage demands, phased-out mitigation measures, and a more backward-looking inflation process; scenario simulations quantify these risks.

### Section 2 — Passthrough of oil prices and inflation to wages
- Main empirical observations:
  - Passthrough of oil prices to wages is more than twice as high when underlying inflation already exceeds 4 percent, suggesting a risk that the ongoing high inflation episode could increase the passthrough to wages more persistently.
  - Empirical analysis follows Baba and Lee (2022) and estimates passthrough for European advanced economies and Portugal between 2000 and 2019.
  - Two specifications are considered:
    - Specification 1: regress wage inflation on the past four quarters of oil price inflation while controlling for the past four quarters of wage inflation, quarterly changes in unemployment rates and nominal effective exchange rates. Oil price developments are assumed exogenous.
    - Specification 2: regress wage inflation on the past four quarters of inflation while using oil price inflation as an instrument for past inflation, keeping the rest of variables unchanged from Specification 1.
- Quantitative findings — Specification 1:
  - Estimated coefficients on lagged inflation over the local projection horizon are statistically not significant.
  - Coefficients suggest a 1 percent increase in oil price raises wage growth by 0.02 percentage points (peak value) in Portugal during the first year.
  - For Advanced economies in Europe, the estimated coefficient is 0.03 percentage points during the first year.
  - Impact of higher oil prices on wages dissipates fully over the year and at a somewhat faster pace in Portugal compared to other European Advanced economies.
  - Given oil price rises of 65 percent in 2021 and 40 percent in 2022, this implies some 1.3 and 0.8 percentage point increase in wage growth in 2021 and 2022 respectively, ceteris paribus.
- Quantitative findings — Specification 2:
  - A 1 percentage point increase in inflation caused by the oil price shocks is associated with a peak wage growth of 1.2 percentage point for Portugal during the first year.
  - The same shock is associated with a 1.4 percentage point increase for other advanced European economies during the first year.
- Implications:
  - These results provide a cautionary note on the overall assessment of a low risk of wage-price spiral in Portugal.
  - Analysis based on the estimated Phillips curve suggests inflation in Portugal has likely peaked, and inflation is projected to ease in 2023 and 2024—driven by falling energy prices and in the context of anchored expectations.
  - Upside risks to inflation include: a more backward-looking inflationary process; energy prices remaining elevated for longer; and sustained wage-inflation increases induced by energy-price pressures.
  - Policies should remain focused on inflation reduction given unprecedented dynamics and unusual forecast uncertainty.
- Institutional considerations on wage formation:
  - The econometric exercise does not consider institutional factors impacting wage formation in individual countries.
  - Wages in Portugal are set under sectoral collective agreements, which are (in most cases) negotiated during the first half of the year. This may explain the only moderate passthrough of inflation to wages observed in 2022, as many collective wage contracts had already been set before inflation started picking up in 2022H2.
  - Collective wage contracts in 2023 may reflect not only inflation expectations for the rest of 2023 but also real wage losses observed in 2022.

*Prepared by Kamil Dybczak and Ippei Shibata; IMF Selected Issues Paper SIP/2023/044 (completed June 1, 2023).*

### Section 1

### sipea2023044 - Section 1

### A. Stylized Facts
- Before the recent energy crisis, headline and core inflation in Portugal "hovered below 2 percent" for most of the last decade.
- Core inflation is defined as headline inflation excluding energy and unprocessed food prices.
- Portugal’s inflation has been strongly correlated with the euro area (EA), but often below the EA level since 2010, driven mostly by non-energy industrial goods such as clothing and footwear.
- Tourism-related prices fell by "almost 10 percent" during the Covid pandemic, contributing to Portugal’s inflation moving further below the EA level.
- Portugal’s HICP composition: weight of food and non-alcoholic beverages has been "above the EA level since 2012 (at over 20 percent)"; weight of housing, water, electricity, and gas is "10 percent" in Portugal versus "16 percent" for the EA.
- Imputing average EA weights to Portugal would raise Portugal’s inflation by only "about 0.2 pp" above its actual level in 2021 and 2022.
- Passthrough dynamics in 2022:
  - Energy price passthrough to Portugal was "about 9 percent increase y/y" in March 2022 versus "about 47 percent for EA".
  - Policy measures (reduction in network access tariffs, tax exemptions on fuel excises and VAT, Iberian price cap announced mid-2022 and effective in H2) muted energy passthrough.
  - Headline inflation peaked in "October 2022 (10.6 percent y/y)" and then trended downward.
  - Core inflation exceeded EA level in early 2022 and "has hovered around 8 percent since September 2022".
- Consumer price expectations mirrored headline inflation trends, picked up from early 2021, and exceeded EA averages by end-2022; they began declining during 2022H2.

### B. Drivers of Inflation — The Phillips Curve
- Empirical approach and data:
  - Estimated a standard Phillips curve relating inflation to past and expected inflation, slack, energy and food prices (in domestic currency, weighted by HICP shares), and other external price pressure (weighted import producers' prices).
  - Lags for external price pressures and food prices included to allow longer passthrough.
  - Estimation sample: "2000: Q1 to 2022: Q4" for 27 advanced economies (list includes PRT).
- Key estimation outcomes and comparative facts:
  - Relationship between slack (unemployment gap) and headline and core inflation is negative and significant for both Portugal and other advanced economies (AE), and of similar magnitude.
  - Backward- and forward-looking inflation expectations play comparable roles in Portugal and AE countries.
  - Passthrough coefficients for food prices and external price pressure are positive but smaller for Portugal than for the AE group.
- Contributions to Portugal’s 2022 inflation:
  - The Phillips curve model explains "about ¾" of Portugal’s inflation in 2022 (model performs slightly better for Portugal than for the AE group, where it explained at most "60 percent").
  - Contributions (2022, headline inflation):
    - Food prices: "about 3.5 pp".
    - External price pressures: "about 2.5 pp" (larger for Portugal than for AE, consistent with Portugal’s reliance on imported inputs).
    - Energy prices: contribution estimated to be below the AE average (reflecting domestic energy price policies and lower HICP energy weight).
    - Unemployment gap: only a small impact for AE and "almost no impact for Portugal".
    - Inflation expectations: despite rising since 2021, they remained anchored and "have driven inflation in the opposite direction than the remaining factors since 2022H2".
- Factors potentially driving the unexplained inflation residual in 2022:
  - Non-linear effects of exceptionally large commodity price changes and possible alteration of the inflation process after the pandemic and Russia’s war in Ukraine.
  - Indicators may not fully capture spillovers between inflation components after the pandemic.
  - Country-specific contributors in Portugal:
    - Labor market tightness: unemployment rate remains below pre-pandemic level and below estimated equilibrium; job vacancies per unemployed and firms reporting labor shortages have risen.
    - Administered prices and policy measures: Iberian cap estimated to have reduced electricity prices by "about 16 percent".
    - Wage growth: wages (approximated by compensation of employees) grew generally above the EA average since 2017, and in 2022 nominal wages increased "6.1 percent" versus headline inflation "8.1 percent" in 2022; real wages rose in 2022H1 and fell in 2022H2.
    - Tourism: pickup in tourism-related prices (e.g., hotels and restaurants) of "13 percent" in Portugal versus "7 percent" for the EA average contributed to higher inflation.

### C. Inflation Projections
- Model-based baseline:
  - The Phillips curve model predicts headline and core inflation in Portugal and AE countries to decline to "about 2 percent by the end of 2024", driven by larger slack, lower energy prices, and lower external price pressures.
  - In the short run, falling commodity prices mainly reduce headline inflation; core inflation declines only through second-round effects with some lag.
- Staff and national projections:
  - Staff baseline (March 2023 WEO assumptions) expects headline and core inflation to decline more gradually, "reaching the 2 percent target only after 2025" (accounts for factors not captured by the model such as minimum wage growth and labor market tightness).
  - Banco de Portugal (March 2023) projects slower convergence, "reaching 2 percent in the course of 2025".
- Risk assessment and scenario simulations:
  - Model uncertainty: if 2022 forecast errors fade only slowly, the model may underestimate near-term inflation.
  - Key simulation outcomes:
    - A change in the unemployment gap by "2 pp" (decrease/increase) would raise/lower headline and core inflation by "about 0.5 pp over next four quarters".
    - A temporary de-anchoring of inflation expectations higher by "1 pp" would elevate headline and core inflation "temporarily by some 1 p p over the next 4 quarters".
    - A "20 percent" higher/lower energy and food price shock would increase headline inflation by "1 to 2 pp" and increase core inflation by "less than 1 percent".
    - If the inflation formation becomes more backward-looking (increasing the coefficient on past inflation in the Phillips curve to "0.8" — level observed pre-1990), headline inflation would increase by "about 2 pp" and core by "about 1 pp", with effects dampening over time as long as inflation expectations remain anchored.

### D. Is There a Risk of a Wage-Inflation Spiral?
- Literature evidence summarized:
  - Recent studies suggest the risk of sustained wage-price spirals is present but "contained so far" in advanced economies.
  - Wage dynamics in AEs are mostly driven by labor market conditions and inflation expectations, not past inflation (Alvarez et al, 2022).
  - Historical analysis of 79 wage-price spiral episodes identified 29 episodes similar to the ongoing episode (characteristics: i) increasing year-on-year inflation, ii) positive nominal wage growth, iii) negative real wage growth, iv) flat or falling unemployment). These episodes typically did not produce sustained wage-price spirals; inflation and nominal wage growth tended to stabilize afterwards.
  - Baba and Lee (2022): in response to a "10 percent" oil price shock, wages typically increase by "0.3 percent over three years" and then stabilize, suggesting oil-price shocks have not typically generated wage-price spirals.

### E. Conclusions (select highlights)
- Portugal’s recent inflation surge was largely driven by food and external price pressures; energy contributed less than in many EA peers due to policy measures and lower HICP energy weight.
- The estimated Phillips curve explains "about ¾" of Portugal’s inflation in 2022 but leaves an unexplained residual that may reflect nonlinear passthrough, post-pandemic structural shifts, labor market tightness, administered price dynamics, wage developments, and tourism price dynamics.
- Under baseline assumptions, inflation is projected to decline toward "about 2 percent by the end of 2024" in the model, while staff and Banco de Portugal projections expect slower convergence ("after 2025" and "in the course of 2025", respectively).
- Risks to faster disinflation include de-anchoring of expectations, tighter labor markets prompting higher wage demands, phased-out mitigation measures, and a more backward-looking inflation process; scenario simulations quantify these risks (see C. Inflation Projections).

*Prepared by Kamil Dybczak and Ippei Shibata; IMF Selected Issues Paper SIP/2023/044 (completed June 1, 2023).*

### Section 2

### sipea2023044 - Section 2

### Passthrough of oil prices and inflation to wages
- Passthrough of oil prices to wages is more than twice as high when underlying inflation already exceeds 4 percent, suggesting a risk that the ongoing high inflation episode could increase the passthrough to wages more persistently.
- An empirical analysis of passthrough of inflation to wages follows Baba and Lee (2022) and estimates the passthrough for European advanced economies and Portugal between 2000 and 2019.
- Two specifications are considered:
  - Specification 1: regress wage inflation on the past four quarters of oil price inflation while controlling for the past four quarters of wage inflation, quarterly changes in unemployment rates and nominal effective exchange rates. Oil price developments are assumed exogenous.
  - Specification 2: regress wage inflation on the past four quarters of inflation while using oil price inflation as an instrument for past inflation, keeping the rest of variables unchanged from Specification 1.

### Quantitative findings
- Specification 1:
  - The estimated coefficients on the lagged inflation over the local projection horizon are statistically not significant.
  - The coefficients suggest a 1 percent increase in oil price raises wage growth by 0.02 percentage points (peak value) in Portugal during the first year.
  - For Advanced economies in Europe, the estimated coefficient is 0.03 percentage points during the first year.
  - The impact of higher oil prices on wages dissipates fully over the year and at a somewhat faster pace in Portugal compared to other European Advanced economies.
  - Given oil price rises of 65 percent in 2021 and 40 percent in 2022, this implies some 1.3 and 0.8 percentage point increase in wage growth in 2021 and 2022 respectively, ceteris paribus.
- Specification 2:
  - A 1 percentage point increase in inflation caused by the oil price shocks is associated with a peak wage growth of 1.2 percentage point for Portugal during the first year.
  - The same shock is associated with a 1.4 percentage point increase for other advanced European economies during the first year.
- These results provide a cautionary note on the overall assessment of a low risk of wage-price spiral in Portugal.

### Inflation dynamics, projections, and risks
- Analysis based on the estimated Phillips curve for Portugal suggests:
  - The recent surge in inflation has been driven by external price pressures and to some extent by labor market tightness, beyond the predominant role of commodity prices.
  - Inflation in Portugal has likely peaked, and inflation is projected to ease in 2023 and 2024—driven by falling energy prices and in the context of anchored expectations.
  - The downward path should be sustained under most alternative assumptions.
- Upside risks to inflation are identified:
  - Inflation would increase if the inflationary process became backward looking.
  - Inflation would increase if energy prices remained elevated for longer.
  - Inflation would increase if wage-inflation increases induced by pressures from energy prices become sustained.
- While these risks appear contained so far, the unprecedented nature of recent inflation dynamics and unusual forecast uncertainty point to the need for policies to remain focused on inflation reduction.

### Institutional considerations on wage formation
- The econometric exercise does not consider institutional factors impacting wage formation in individual countries.
- Wages in Portugal are set under sectoral collective agreements, which are (in most cases) negotiated during the first half of the year. This may explain the only moderate passthrough of inflation to wages observed in 2022, as many collective wage contracts had already been set before inflation started picking up in 2022H2.
- Conversely, collective wage contracts in 2023 may reflect not only inflation expectations for the rest of 2023 but also real wage losses observed in 2022.

*Source: sipea2023044 - Section 2*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2023/english/sipea2023044.pdf_