A Bottom-Up Reduced Form Phillips Curve for the Euro Area
IMF Working Papers, December 16, 2022
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Bibliographic details
- Authors: Thomas McGregor, Frederik G Toscani
- Published: December 16, 2022
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9798400219108.001
Model and approach
- Develops a bottom-up model of inflation in the euro area based on:
- a set of augmented Phillips curves for seven sub-components of core inflation, and
- auxiliary regressions for non-core items.
- Disaggregated structure improves forecasting performance relative to a standard one-equation Phillips curve, particularly since the onset of the Covid-19 pandemic in early-2020 and the subsequent energy shocks.
- Emphasizes the utility of the bottom-up approach as a complement to existing forecasting tools by:
- improving forecast accuracy,
- shedding additional light on drivers of inflation, and
- providing a framework to apply ex-post judgement in a structured way.
Key empirical findings
- International energy and food prices play a key role in explaining the recent surge in inflation:
- As of Q2 2022, they account for 75 percent of the increase in headline inflation.
- As of Q2 2022, they account for 30 percent of the increase in core inflation.
- Other contributors:
- Economic slack and inflation expectations explain another 10 percent of the increase in headline inflation.
- Economic slack and inflation expectations explain another 20 percent of the increase in core inflation.
- Unexplained component:
- Around one-third of the increase in core inflation remains unexplained by the model.
Forecasts and projections
- Out-of-sample projections indicate:
- High uncertainty around the inflation path.
- Inflation pressures are unlikely to dissipate quickly.
Implications for forecasters and policymakers
- The bottom-up approach is especially useful in an environment of sectoral shocks because it:
- Improves forecast accuracy relative to aggregate single-equation approaches,
- Identifies the relative contributions of international energy and food prices versus domestic factors such as slack and expectations, and
- Provides a structured framework to incorporate judgement and to interpret sectoral drivers of inflation.
Source: A Bottom-Up Reduced Form Phillips Curve for the Euro Area, Thomas McGregor and Frederik G Toscani, IMF Working Paper No. 2022/260.
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