Euro Area Inflation Research Articles

International Food Commodity Prices and Missing (Dis)Inflation in the Euro Area

AbstractExogenous shifts in international food commodity prices, which are identified using an SVAR model with global harvest shocks as an external instrument, explain almost 30% of euro-area inflation volatility over the medium term and contributed significantly to the twin puzzle of missing (dis)inflation in the era after the Great Recession. International food price shocks have an impact on food retail prices through the food production chain, but also trigger indirect inflationary effects via a depreciation of the euro and, most important, rising wages. Finally, due to asymmetric wage responses, the inflationary effects are very different across member states.

Is euro area lowflation here to stay? Insights from a time‐varying parameter model with survey data

SummaryWe build a time‐varying parameter model that jointly explains the dynamics of euro area inflation and inflation expectations. Our goal is to explain the weak inflation during the post‐financial crisis economic recovery of 2013–2019. We find that the inclusion of survey data leads to a more muted decline of trend inflation in recent years and more economic slack. Moreover, the impact of economic slack and import prices on inflation has recently strengthened, and survey respondents updated their beliefs more actively over the financial crisis period. Our model compares well against restricted specifications in terms of forecast performance and marginal likelihood.

Can central bank communication help to stabilise inflation expectations?

AbstractThis paper examines whether central bank communication stabilises euro area inflation expectations through the information and news channel. A novelty of the study is its use of data from Google Analytics on ECB website traffic as proxy for visitors’ attention to its communication. We conduct several econometric tests with daily data to measure the impact of ECB communication on the information demand of the public and ultimately on inflation expectations. Overall, this study shows that website attention, as captured by search volumes of visitors, influences euro area inflation expectations. We find that increased website attention contributes to narrowing the gap between market‐based forecasts and (the mean of) longer‐term professional inflation expectations. Our findings add to the theoretical evidence on the existence of an information and news channel.

Deep recessions, slowing productivity and missing (dis-)inflation in the euro area

This paper analyses the role of endogenous total factor productivity dynamics in explaining business cycle persistence as well as the missing (dis-)inflation and productivity puzzles in the euro area. We show by means of an estimated medium-scale DSGE model in which TFP evolves endogenously as the result of costly investment in R&D and technology adoption that the endogenous slowdown in total factor productivity can explain the depth and persistence of the output drop and the weak recovery following the double-dip recession in the euro area. Our results suggest that a decrease in R&D efficiency and innovation is key in explaining the pre-crisis euro area productivity slowdown, while as of 2008 a crises-induced drop in technology adoption constitutes the most important factor. We document a flattening of the Phillips curve relationship under the endogenous TFP mechanism, resulting from the interaction between inflation and productivity dynamics. The endogenous reaction in TFP dampens the inflation response over the business cycle and can thus help explain both the moderate fall in euro area inflation during its crises and its sluggish increase in the subsequent recovery.

The COVID-19 Shock and Challenges for Time Series Models

We document the impact of COVID-19 on frequently employed time series models, with a focus on euro area inflation. We show that for both single equation models (Phillips curves) and Vector Autoregressions (VARs) estimated parameters change notably with the pandemic. In a VAR, allowing the errors to have a distribution with fatter tails than the Gaussian one equips the model to better deal with the COVID-19 shock. A standard Gaussian VAR can still be used for producing conditional forecasts when relevant off-model information is used. We illustrate this by conditioning on official projections for a set of variables, but also by tilting to expectations from the Survey of Professional Forecasters. For Phillips curves, averaging across many conditional forecasts in a thick modelling framework offers some hedge against parameter instability.

The Case for a Positive Euro Area Inflation Target: Evidence from France, Germany and Italy

The Case for a Positive Euro Area Inflation Target: Evidence from France, Germany and Italy

The Case for a Positive Euro Area Inflation Target: Evidence from France, Germany and Italy

The Case for a Positive Euro Area Inflation Target: Evidence from France, Germany and Italy

The Case for a Positive Euro Area Inflation Target: Evidence from France, Germany and Italy

The Case for a Positive Euro Area Inflation Target: Evidence from France, Germany and Italy

Anchoring of Consumers’ Long-Term Euro Area Inflation Expectations During the Pandemic

This paper analyses the results from a new monthly survey of consumers’ euro area inflation expectations before and during the pandemic. We find that consumers’ longterm euro area inflation expectations have remained elevated above the ECB’s inflation aim throughout the pandemic. Moreover, their distributions have continuously shown a greater probability of high inflation (2pp above the ECB’s inflation aim of 2%) than of deflation during the pandemic. These results suggest that during the pandemic consumers’ long-term euro area inflation expectations have been de-anchored on the upside rather than on the downside. This is in contrast to concerns by ECB policymakers about a de-anchoring on the downside during the pandemic. We find that during the pandemic consumers’ expected probabilities in the long term of deflation in the euro area have been above those from the ECB Survey of Professional Forecasters, and below those implied by options. We also find based on consumers’ point inflation expectations and on three measures calculated directly from their individual expected probability distribution, that consumers’ long-term euro area inflation expectations have been better anchored for higher education levels and for higher net household income.

The Case for a Positive Euro Area Inflation Target: Evidence from France, Germany and Italy

Using micro price data underlying the Harmonized Index of Consumer Prices in France, Germany and Italy, we estimate relative price trends over the product life cycle and show that minimizing price and mark-up distortions in the presence of these trends requires targeting a significantly positive inflation target. Relative price trends shift the optimal inflation target up from a level of zero percent, as suggested by the standard sticky price literature, to a range of 1.1%- 2.1% in France, 1.2%-2.0% in Germany, 0.8%-1.0% in Italy, and 1.1-1.7% in the Euro Area (three country average). Differences across countries emerge due to systematic differences in the strength of relative price trends. Other considerations not taken into account in the present paper may push up the optimal inflation targets further. The welfare costs associated with targeting zero inflation turn out to be substantial and range between 2.1% and 4.5% of consumption in present-value terms.

Can Central Bank Communication Help to Stabilise Inflation Expectations?

This paper examines whether central bank communication stabilises euro area inflation expectations through the information and news channel. A novelty of the study is its use of data from Google Analytics on ECB website traffic as proxy for visitors’ attention to its communication. We conduct several econometric tests with daily data to measure the impact of ECB communication on the information demand of the public and ultimately on inflation expectations. Overall, this study shows that website attention, as captured by search volumes of visitors, influences euro area inflation expectations. We find that increased website attention contributes to narrowing the gap between market-based forecasts and (the mean of) longer-term professional inflation expectations. Our findings add to the theoretical evidence on the existence of an information and news channel.

Combining Bayesian VARs with Survey Density Forecasts: Does it Pay Off?

This paper studies how to combine real-time forecasts from a broad range of Bayesian vector autoregression (BVAR) specifications and survey forecasts by optimally exploiting their properties. To do that, it compares the forecasting performance of optimal pooling and tilting techniques, including survey forecasts for predicting euro area inflation and GDP growth at medium-term forecast horizons using both univariate and multivariate forecasting metrics. Results show that the Survey of Professional Forecasters (SPF) provides good point forecast performance, but also that SPF forecasts perform poorly in terms of densities for all variables and horizons. Accordingly, when the model combination or the individual models are tilted to SPF's first moments, point accuracy and calibration improve, whereas they worsen when SPF's second moments are included. We conclude that judgement incorporated in survey forecasts can considerably increase model forecasts accuracy, however, the way and the extent to which it is incorporated matters.

Forecasting inflation in the euro area: countries matter!

We construct a Bayesian vector autoregressive model with three layers of information: the key drivers of inflation, cross-country dynamic interactions, and country-specific variables. The model provides good forecasting accuracy with respect to the popular benchmarks used in the literature. We perform a step-by-step analysis to shed light on which layer of information is more crucial for accurately forecasting medium-run euro area inflation. Our empirical analysis reveals the importance of including the key drivers of inflation and taking into account the multi-country dimension of the euro area. The results show that the complete model performs better overall in forecasting inflation excluding energy and unprocessed food over the medium term. We use the model to establish stylized facts on the euro area and cross-country heterogeneity over the business cycle.

An empirical analysis of loan supply and demand in the euro area

Using a cointegrated vector autoregressive model (CVAR), this paper empirically examines the supply and demand for euro area loans to the non-financial private sector for the sample 1981 to 2017. We distinguish between loan demand and supply and disentangle the impact of the financial crisis on loans from conventional drivers. Applying I(2) cointegration analysis, we find two long-run (polynomial) cointegration relations and identify them as loan demand and supply functions. Despite rejecting long-run price homogeneity for euro area loans in the unrestricted model, we identify a stable system with (long-run) loan supply and demand functions based on conventional drivers and housing wealth. In terms of forecasting properties, we show that the loan demand function helps to improve the accuracy of euro area inflation forecasts for horizons of up to 8 quarters ahead and for loan forecasts for horizons of up to 2 quarters ahead, while the loan supply function does not have this property.

Unravelling the Secrets of Inflation in the Euro Area – A Frequency Decomposition Approach

Abstract Research background: The study contributes to the field of monetary economics. In the practice of monetary policy, all central banks have a vivid interest in distinguishing between signals and noise in the data. Purpose: The study investigates from a frequency-domain perspective the interlinkages between money, loans, inflation and real GDP for the euro area. Research methodology: The research methodology includes a combination of a time-series single-equation estimation approach with a frequency decomposition analysis. Results: Broad monetary measures are found to add positively and significantly to euro area inflation over longer horizons and so do loan developments. Over medium-term horizons, real economic and exchange rate developments seem to exert a significant impact. Over shorter horizons, none of the variables under consideration affects inflation in a significant way. Robustness checks confirm the overall results. Monetary aggregates also seem to explain house price developments at lower frequencies. In addition, real GDP and exchange rate (possibly reflecting an income effect) exert a strong and significant impact, while stock prices show a substitution effect. Novelty: The paper adds to the studies focusing on the driving forces of inflation and growth over various time horizons, with the conclusion that central banks should adopt medium-term orientation and always closely monitor real, monetary and exchange rate developments in conjunction.

Stochastic model specification in Markov switching vector error correction models

Abstract This paper proposes a hierarchical modeling approach to perform stochastic model specification in Markov switching vector error correction models. We assume that a common distribution gives rise to the regime-specific regression coefficients. The mean as well as the variances of this distribution are treated as fully stochastic and suitable shrinkage priors are used. These shrinkage priors enable to assess which coefficients differ across regimes in a flexible manner. In the case of similar coefficients, our model pushes the respective regions of the parameter space towards the common distribution. This allows for selecting a parsimonious model while still maintaining sufficient flexibility to control for sudden shifts in the parameters, if necessary. We apply our modeling approach to real-time Euro area data and assume transition probabilities between expansionary and recessionary regimes to be driven by the cointegration errors. The results suggest that the regime allocation is governed by a subset of short-run adjustment coefficients and regime-specific variance-covariance matrices. These findings are complemented by an out-of-sample forecast exercise, illustrating the advantages of the model for predicting Euro area inflation in real time.

Does the Phillips Curve Help to Forecast Euro Area Inflation?

We find that it does, but choosing the right specification is not trivial. We unveil notable model instability, with breaks in the performance of most simple Phillips curves. Euro area inflation was particularly hard to forecast in the run-up to the EMU and after the sovereign debt crisis, when the trend and for the latter period, also the amount of slack, were harder to pin down. Yet, some specifications outperform a univariate benchmark most of the time and are thus a useful element in a forecaster's toolkit. We base these conclusions on an extensive forecast evaluation over 1994 - 2018, an extraordinarily long period by euro area standards. We complement the analysis using real-time data over 2005-2018. As lessons for practitioners, we find that: (i) the key type of time variation to consider is an inflation trend; (ii) a simple filter-based output gap works well overall as a measure of economic slack, but after the Great Recession it is outperformed by endogenously estimated slack or by estimates from international economic institutions; (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, especially when density forecasts are of interest, and finally, (v) averaging over a wide range of modelling choices offers some hedge against breaks in forecast performance.

Non-Linear Exchange Rate Pass-Through to Euro Area Inflation: A Local Projection Approach

How long does it take for exchange rate changes to pass through into inflation? Does it make a difference whether the exchange rate depreciates or appreciates? Do relatively large exchange rate changes entail more exchange rate pass-through? In this paper, we examine possible non-linearities in the transmission of exchange rate movements to import and consumer prices in all 19 euro area countries as well as the euro area as a whole from 1997 to 2019Q1. We extend a standard single-equation linear framework with additional interaction terms to account for possible non-linearities and apply local projections to obtain state-dependent impulse response functions. We find that (i) euro area consumer and import prices respond significantly to exchange rate movements after one year, responding more when the exchange rate change is relatively large; and (ii) euro appreciations and depreciations affect the level of euro area exchange rate pass-through in a symmetric fashion; (iii) for euro area countries results differ for import and consumer prices and across countries. JEL Classification: E31, F41

The Anchoring of Long-Term Inflation Expectations of Consumers: Insights from a New Survey

We provide new evidence on the level and probability distribution of consumers’ longterm expectations of inflation in the euro area and the Netherlands, using a representative Dutch survey. We find that consumers’ long-term (ten years ahead) euro area inflation expectations are not well anchored at the ECB’s inflation aim. First, median long-term euro area inflation expectations are 4%, 2pp above the ECB’s inflation aim of 2%. Second, individual probability distributions of long-term euro area inflation expectations show that expected probabilities of higher inflation (2pp or more above the ECB’s inflation aim) are much higher, at 28% on average, than those of lower inflation (2pp or more below the ECB’s inflation aim), at 12%. This suggest that the de-anchoring of Dutch consumers’ long-term euro area inflation expectations is mainly due to expected high inflation, rather than to expected low inflation (or deflation). This finding is in contrast to recent concerns by ECB monetary policymakers about a possible de-anchoring of long-term inflation expectations on the downside. Furthermore, we find that consumers’ long-term euro area inflation expectations are significantly higher if respondents have lower incomes. Based on measures of anchoring calculated directly from individual consumers’ probability distributions of expected long-term inflation, namely the probability of inflation being close to target, the probability of inflation being far above target, and the probability of deflation, we also find that long-term euro area inflation expectations are better anchored for consumers with higher net household income.

Asymmetry in the Conditional Distribution of Euro-area Inflation

Macroeconomic conditions are among the key determinants of the inflation outlook. This paper studies how business cycles affect the conditional distribution of euro-area inflation forecasts. Using a quantile regression approach, I estimate the conditional distribution of inflation to assess the impact of business cycle conditions over time and the possible asymmetries across quantiles of inflation. Interestingly, downside risks to inflation forecasts are related to the business cycle while upside risks are instead relatively stable over time and are not affected by the state of the economy.