Publication - Low inflation in the euro area: Causes and consequences - by Matteo Ciccarelli, Chiara Osbat
Since the Great Recession, inflation worldwide has become more difficult to understand, and economists speak of a twin puzzle. First, inflation was expected to be lower between 2009 and end-2011, given the severity and length of the recession in most advanced economies (missing disinflation).
Second, more recent global developments point in the opposite direction (missing inflation): inflation was expected to be higher in most advanced economies after 2012, on the back of the ongoing recovery. Instead, inflation was persistently below target largely due to global disinflationary shocks that were mostly related to the fall in the price of oil since 2011. Since mid-2014, this fall in oil prices has become even more severe. This prolonged and surprising low inflation prompted monetary policy action through non-standard measures, without which inflation would have arguably been much lower.
This paper presents research conducted by a network of experts from the European System of Central Banks (ESCB) – i.e. the 28 national central banks of the European Union (EU) and the European Central Bank. It focuses on the second puzzle after 2012 and on the euro area, and addresses missing inflation through three interrelated questions: (i) Why has inflation been low? (ii) What have been the consequences? (iii) Has monetary policy been successful in counteracting them and through which channels?
Between 2012 and mid-2016, both headline and core inflation in the euro area and in most member states have been lower than the forecasts produced by the Eurosystem and by other institutions. Over the same period, there are indications that trend inflation declined and inflation persistence increased.
There is an increasing literature pointing to possible structural changes (e.g. demographics, technology), which could be consistent with decreasing trend inflation. However, a key finding of this paper is that the missing inflation was rather due to cyclical factors, both global and domestic. Global shocks and commodity prices were the main drivers of the disinflation in the euro area, but after 2012 domestic drivers were also very important.
For domestic sources of inflation, one of the main conclusions of this paper is that the Phillips curve remains a useful tool in understanding inflation dynamics in the most recent disinflation period. In the euro area and in some euro area countries – especially where labour market slack has been large and protracted – the sensitivity of inflation to economic slack has recently strengthened.
The main potential consequence of low inflation is that it may become self-sustaining through three main channels: de-anchoring of inflation expectations, competitiveness, and debt deflation. The paper discusses the latter two theoretically and dives empirically in the expectations channel.
Some empirical studies suggest that potential risks of a de-anchoring of inflation expectations might have emerged in 2014, following a prolonged period of low inflation due to a sequence of adverse shocks at the effective lower bound (ELB) of interest rates. This is consistent with declining indicators of trend inflation, the finding that disinflationary shocks have been both global and domestic, and the evidence of a recent increase in the intercept of the Phillips curve in the euro area.
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