Does the Phillips curve help to forecast euro area inflation?

Abstract

We find that it does, but choosing the right specification is not trivial. Based on an extensive forecast evaluation we document notable forecast instabilities for most simple Phillips curves. Euro area inflation was particularly hard to forecast in the run-up to the Economic and Monetary Union and after the sovereign debt crisis, when the trends—and, for the latter period, also the amount of slack—were harder to pin down. Yet, some specifications outperform a univariate benchmark and point to the following lessons: (i) the key type of time variation to consider is an inflation trend; (ii) a simple filter-based output gap works well, but after the Great Recession it is outperformed by endogenously estimated slack or by “institutional” estimates; (iii) external variables do not bring forecast gains; (iv) newer-generation Phillips curve models with several time-varying features are a promising avenue for forecasting; and (v) averaging over a wide range of modelling choices helps.