Euro Area Inflation: Why Low For So Long?

IMF Blog, August 28, 2018

Source details

Canonical URL: Euro Area Inflation: Why Low For So Long?

Other formats

Bibliographic details

Authors: Yasser Abdih, Li Lin, Anne-Charlotte Paret Onorato
Published: August 28, 2018

Overview and context

Authors: Yasser Abdih, Li Lin, Anne-Charlotte Paret Onorato
Date: August 28, 2018
Context: The euro area economy is in its fifth year of recovery, unemployment is close to its pre-crisis level and the output gaps of most countries have closed. Yet, core inflation continues to be low, notwithstanding temporarily high headline inflation due to higher energy prices.

The puzzle

Apparent breakdown of the Phillips curve: over the past five years, core inflation appears unresponsive to improving labor market conditions.
Two distinct episodes highlighted:
- 2012 to 2014: “missing disinflation” — inflation stayed at relatively high levels despite high and increasing unemployment.
- 2014 to 2017: “missing inflation” — little inflation pressure despite considerable reductions in labor market slack.
Alternative explanations discussed in literature: a broken Phillips curve, difficulties in correctly quantifying slack, or low global inflation.

Key findings (model and empirical results)

A standard Phillips curve specification is used: core inflation depends on inflation expectations, past inflation, and the unemployment gap.
Stability of relationship:
- The relationship between core inflation and unemployment is stable; inflation continues to react to labor market developments.
- This stability holds when using alternative slack measures (output gap, broader unemployment measures that include underemployed and marginally attached workers).
Role of inflation persistence:
- Euro area inflation displays strong persistence: the coefficient on past inflation is high (much higher than for US inflation).
- The coefficient on inflation expectations is much lower for the euro area than for the US.
- Implication: after a period of weak demand and low inflation, it takes a much longer period of strong demand to return inflation to the inflation objective — there is a substantial time lag in transmission from labor market improvements to prices.
Global factors tested and results:
- Global variables included: foreign output gap, foreign inflation, non-oil import prices, oil prices, and the nominal effective exchange rate.
- Empirical result: global factors contribute less to inflation dynamics than domestic factors and were not consistently deflationary in recent years.
Conclusion on the puzzle: Accounting for high persistence and the implied time lag reconciles observed low core inflation with a conventional Phillips curve — core inflation eventually aligns with labor market developments.

Policy implications and recommendations

Convergence toward the ECB’s medium-term inflation objective is likely to be gradual due to persistence in the inflation process.
Risk of premature policy tightening:
- A too early withdrawal of monetary accommodation could be a mistake with long-lived consequences.
Recommendation for monetary stance:
- Reinforces the case for being “patient, prudent and persistent”.
- Underlines the importance of the ECB’s commitment to keep policy rates at their current, extraordinary low levels—at least through next summer—and as long as necessary.
- Rationale: maintaining accommodation supports the slow process of returning inflation to its objective via stronger demand and well-anchored inflation expectations.

IMF blog post: Euro Area Inflation: Why Low For So Long? (August 28, 2018)

Euro Area Inflation: Why Low For So Long?

Source details

Other formats

Bibliographic details

Overview and context

The puzzle

Key findings (model and empirical results)

Policy implications and recommendations

References