## Euro Area Inflation: Why Low For So Long?

_IMF Blog, August 28, 2018_

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

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### 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)*

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## References

- [https://www.imf.org/wp-content/uploads/2018/08/eng-august-13-eur1-1.png](https://www.imf.org/wp-content/uploads/2018/08/eng-august-13-eur1-1.png)
- [https://www.imf.org/wp-content/uploads/2018/08/eng-august-13-eur2.png](https://www.imf.org/wp-content/uploads/2018/08/eng-august-13-eur2.png)
- [new study](http://www.imf.org/en/Publications/WP/Issues/2018/08/22/Understanding-Euro-Area-Inflation-Dynamics-Why-So-Low-for-So-Long-46134?cid=em-COM-123-37618)
- [https://www.imf.org/wp-content/uploads/2018/08/copy-eng-august-13-eur3-1.png](https://www.imf.org/wp-content/uploads/2018/08/copy-eng-august-13-eur3-1.png)
- [The IMF and Europe](http://www.imf.org/external/region/eur/index.aspx)
- [Euro area: Time to tackle the tough challenges](https://www.imf.org/en/News/Articles/2018/07/17/na071918-euro-area-time-to-tackle-the-tough-challenges)
- [Euro area Article IV](http://www.imf.org/en/Publications/CR/Issues/2018/07/18/Euro-Area-Policies-2018-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-46096)
- [Euro area selected issues](http://www.imf.org/en/Publications/CR/Issues/2018/07/18/Euro-Area-Policies-Selected-Issues-46097)

_Source: https://www.imf.org/en/blogs/articles/2018/08/28/euro-area-inflation-why-low-for-so-long_