Macroeconomic models may need adjustment to account for recent inflation events, ECB Vice President says

In a Panel remark at the Jackson Hole Economic Policy Symposium, Vítor Constâncio, Vice-President of the ECB said that establishing whether the Phillips Curve (the historical inverse relationship between inflation and unemployment)  was indeed flattening is crucial to understand the missing disinflation in the wake of the Great Recession and the excessive disinflation after 2012 in the euro area.


If confirmed, the flattening of the Phillips curve would be relevant for monetary policy because that relationship was the traditional linchpin of the transmission mechanism that gave central banks control of inflation. More important, however, was the emergence, after the Great Recession, of a twin puzzle: first, missing disinflation in 2009-11, and second, excessive disinflation after 2012, particularly in Europe. Inflation dynamics since the Great Recession have shown signs of instability that have led to a sequence of systematic forecast errors. The two puzzles of “missing disinflation” and successive “excessive disinflation” triggered a surge of new research around the Phillips curve and its possible demise, which seems to have been prematurely foretold.

There is an important common factor in inflation in the advanced economies that helps explain national inflation dynamics. The current phase of low inflation, aside from commodity price developments, is significantly influenced by negative demand shocks both at the global and national level. In particular, the recent low inflation in the euro area was largely triggered by domestic demand weakness, which probably led to a larger degree of economic slack than was predicted by the usual methods.

The Phillips curve seems to survive the recent reassessment and is still a valid tool of analysis in the euro area, meaning that a sustained recovery in inflation is conditional upon real activity and inflation expectations. The link between inflation and real activity appears to have strengthened in the euro area recently. Provided our policies are able to significantly reduce the output gap, we can rely on a material effect to help bring the inflation rate closer to target.

Source: ECB