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Understanding Euro Area Inflation Dynamics: Why So Low for So Long?

Abdih Y., Lin L., Paret A-C., (2018), «Understanding Euro Area Inflation Dynamics: Why So Low for So Long?», Working Paper No. 18/188, IMF, 22 Αυγούστου

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.

Euro area inflation has been below the European Central Bank’s (ECB) inflation objective since 2013, adjusting very slowly to tightening labor market conditions. Tremendous efforts have been spent by the ECB to guide inflation to the objective of close to,
but below 2 percent. These included lowering the policy rate to zero and carrying out a range of unconventional monetary policies, such as the negative deposit rate and asset purchases. These efforts have underpinned the recovery, with unemployment rate declining from the peak of 12.1 percent in 2013 to 8.5 percent by Q2 2018 and more than 7.5 million jobs being created. However, inflation has responded to policy efforts only to a lesser extent. As of June 2018, the less volatile core inflation measures were still below 1.5 percent, even though the remaining unemployment was estimated as being mostly structural.

The seemingly decoupling of euro area inflation and labor market developments arose in 2012. Figure 2 shows the euro area core
inflation together with the unemployment gap. Over the period of 2000Q1 to 2011Q4, there appeared to be a well-established Phillips curve (in green, i.e., a negative relationship between inflation and domestic economic slack). However, since 2012, an inflation puzzle
emerged. First there was a “missing disinflation” episode over the two years starting early 2012, with inflation reacting slowly to higher unemployment rates (in blue). Thereafter followed a “missing inflation” period (in yellow), with inflation being remarkably stable despite considerable declines in the unemployment rate.