Surprise! Euro Area Inflation Has Fallen

Abstract

Between 2013 and 2014, following the recession triggered by the sovereign debt crisis, euro-area inflation decreased sharply. Although a fall in the inflation rate was to be expected, given the severity of the recession, professional forecasters failed to anticipate it. A possible explanation for this forecast failure lies in a break in the cyclicality of inflation, which was unaccounted for in forecasting models. We probe this explanation in the context of a simple backward-looking Phillips curve and find that the sensitivity of inflation to the output gap has recently increased. We rationalize this result through a structural model, in which a steepening of the Phillips curve arises either from lower nominal rigidities (a decrease in the average duration of prices) or from fewer strategic complementarities in price-setting due to a reduction in the number of firms in the economy.