Exploring Trend Inflation Dynamics in Euro Area Countries

Abstract

This paper analyzes the inflation processes of twelve Euro Area countries over the period 1984:q1-2017:q4. The stylized features of inflation uncover its changing nature and cross-country heterogeneity, in terms of mean, volatility and persistence. After estimation of a wide array of unobserved components models, we isolate trend inflation rates in a framework that allows for time-varying inflation gap persistence and stochastic volatility in both the trend and transitory components. On average, a sizeable share of overall inflation dynamics is accounted for by movements in the trend. In explaining trend dynamics, we consistently find a significant role for short-term inflation expectations, economic slack, and openness variables. However, the accumulated impacts of these are fairly small, except in certain, sustained episodes. This is of policy relevance since the monetary authority might want to respond to shocks that are prone to affect the inflation trend in order to ensure that long-term inflation expectations remain anchored.