Resurrecting the Phillips Curve in Low-Inflation Times

Abstract

I investigate the dynamics of core inflation in Italy, with a special focus on the decline that started in 2012 and the ensuing low-inflation period. Novel composite indicators of labour and financial market conditions are constructed and employed in a factor-augmented Phillips curve framework. Several findings follow. The Phillips curve, apparently dead when based on the unemployment gap or the output gap, is instead correctly underpinned when slack is extracted from the labour market composite indicator: the underlying large set of variables is beneficial for conditionally forecasting core inflation. Second, financial market composite indicators help to better characterize core inflation dynamics in times of unconventional monetary policy and when considering their interactions with economic slack. Third, a steepening of the Phillips curve is evident after 2008, before a stabilization is observed in 2016. These results can inform monetary authorities in their quest for sustained adjustment in the path of inflation.