Vítor Constâncio: Understanding inflation dynamics and monetary policy
Panel remarks by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming,
29 August 2015.
* * *
The accompanying charts (plus slides) can also be found on the European Central Bank's website.
I would like to thank the ECB staff members that have done the econometric work for this intervention, in
particular, Matteo Ciccarelli, Chiara Osbat, Elena Bobeica, Carlos Montes-Galdon and Marco Groß.
Summary
At the 2015 Jackson Hole Economic Policy Symposium, ECB Vice-President Vítor
Constâncio discusses main challenges in understanding inflation dynamics. He reviews
recent developments in euro area inflation and related implications for monetary policy.
Understanding inflation dynamics has become particularly important in present times, in view
of the prolonged low inflation phase. The traditional relationship between slack in the
economy and inflation seems to have weakened significantly in some countries. This
requires a careful examination since that relationship - the Phillips curve - is the traditional
cornerstone of the transmission mechanism giving central banks control of inflation. Inflation
dynamics since the Great Recession have shown signs of instability that have led to a
sequence of systematic forecast errors. The two puzzles of "missing disinflation" in 2009-11
followed by "excessive disinflation" after 2012 triggered a surge of new research around the
Phillips curve and its possible demise.
After reviewing a number of unsettled issues pertaining to the Phillips curve in the economic
literature, such as those related to the measurement of economic slack and inflation
expectations, the discussion note argues that the two puzzles can be explained, and that the
Philips curve for the euro area is alive and well. This is comforting since the opposite result
would raise serious questions about the central bank's capacity to control inflation.
The current phase of low inflation is significantly driven by negative demand shocks at the
global and domestic level, besides commodity price developments. This is certainly the case
for the euro area where the low inflation can largely be explained by domestic demand
weakness, possibly leading to a larger degree of economic slack than indicated by the usual
methods. The link between inflation and real economic activity appears however to have
strengthened in the euro area as of late (steepening of the Phillips curve). We should thus be
able to bring the inflation rate closer to target in the medium term, provided that our policies
are successful in significantly reducing the economic slack.
Outline
1. Introduction
2. Prolonged low inflation: puzzles and forecasting errors
3. Drivers of low inflation in the euro area: domestic or external?
4. The Phillips curve as a vehicle to discuss inflation dynamics:
5. Measuring the economic slack, the slope and its stability;
6. Are hybrid New Keynesian Phillips curves useful in understanding inflation
dynamics?
7. Stability of the coefficients of inflation inertia, economic activity, inflation
expectations and external prices. Limitations of the Phillips curve and the need to
use several different models.
8. Lessons for monetary policy: the use of models and judgement to understand,
forecast and design policies to influence medium-term inflation. Achieving the
inflation target in the euro area.
Introduction
It is a great pleasure to participate in this policy panel with such distinguished fellow
participants. In my remarks today I will discuss the general difficulties in dealing with inflation
dynamics, but I will concentrate on the recent developments in euro area inflation and
discuss their implications for monetary policy.
Understanding inflation dynamics has become particularly important in view of the
low inflation regime now prevailing and because the traditional relationship between slack in
the economy and inflation seems to have weakened significantly in some countries.
Figure 1
If confirmed, the flattening of the Phillips curve would be relevant for monetary policy
because that relationship was the traditional linchpin of the transmission mechanism
that gave central banks control of inflation. The subsequent focus on the role of
expectations and their management in the toolkit of monetary policy reduced but did not
eliminate the relevance of that traditional mechanism. In 2006 both the International
Monetary Fund (IMF) and the Federal Reserve started to highlight a decade-long decline in
the slope of the Phillips curve, i.e. the coefficient of economic slack (IMF (2006), Iakova
(2007) and Roberts (2006)). This decline has been challenged by Gordon (2007 and 2013)
as being too dependent on the Phillips curve specification, being particularly associated with
variants of the New Keynesian Phillips curve (NKPC), but not verified by Gordon's own
"triangle model". Coibion and Gorodnichenko (2015) show that evidence of slope decline is
mixed for the United States. Stock and Watson (2010) say that "there are some hints that the
slope parameter might be smaller at low levels of inflation but these hints are not robustly
confirmed by statistical tests". Stella and Stock (2012) even find signs of a steepening of the
Phillips curve for the United States.
More important, however, was the emergence, after the Great Recession, of a twin
puzzle: first, missing disinflation in 2009-11, and second, excessive disinflation after
2012, particularly in Europe. During the Great Recession (the recession that followed the
financial crisis), inflation in advanced countries did not fall as much as a traditional Phillips
curve and past experiences would have predicted, given the severity and length of the
recession (Williams (2010) and Ball and Mazumder (2011)). Just as puzzling, more recent
global developments point in the opposite direction, since, in spite of the ongoing recovery,
headline inflation rates in advanced (and a few emerging market) economies remain below
target. Clearly, one reason for the low inflation rates is the recent large decline in oil prices.
But core or underlying rates of inflation have also been below average almost everywhere.
The seemingly weakened relationship between inflation and economic slack in the cases of
the two puzzles seemed to have disposed of the Phillips curve. We will see why that is not
true after all.
Ex-post, we are not in the dark: If we exploit all available information we can recover
the dynamics of inflation after the fact fairly well, and rationalise inflation developments
after the financial crisis. For the euro area we can identify two distinct periods of disinflation
in the case of HICP excluding energy and food: the first from 2008 to 2010 and the second
starting in 2012. The analysis is based on a Bayesian VAR1 which includes HICP excluding
energy and food, real activity indicators (real GDP, the unemployment rate and real
investment), external variables (NEER, non-energy commodity prices, oil price in US dollars
and foreign demand) and financial variables (short-term interest rates lending rates and real
loans to non-financial corporations).
Figure 2
Each inflation dip had different origins: the first was mainly due to external factors (falling
energy and food prices), while the second was driven more by domestic sources in an
environment of weak demand.
There is a vast body of literature on the first puzzle of the "missing disinflation", which
offers a variety of explanations: the increased anchoring of expectations by a credible
monetary policy (Bernanke (2010) and IMF (2013)); the continued decline of the
responsiveness to economic slack (IMF (2013)); the increased downward wage rigidities in a
recession that bend the wage Phillips curve (Daly and Hobijn (2014)); the higher
forwardlooking expectations of marginal costs in a dynamic stochastic general equilibrium (DSGE)
model (Del Negro, Giannoni and Schorfheide (2015)); a fall in total factor productivity and
increased costs of working capital (Christiano, Eichenbaum and Trabandt (2014)); a regime
switch in the slope explained by sticky prices and sticky information (Murphy (2014)); or the
role of higher mark-ups of liquidity-constrained firms (Gilchrist, Schoenle, Sim, and Zakrajsek
(2015)). Others pointed to important measurement issues and suggested e.g. using
shortterm unemployment to measure slack (Gordon (2013), Krueger et al. (2014) and Ball and
Mazumder (2014)) or household expectations from surveys to relevantly measure inflation
expectations (Coibion and Gorodnichenko (2015)).
Most of these approaches, besides solving the puzzle a posteriori, also provide new methods
that promise to improve future inflation forecasting, even in the context of reduced-form
Phillips curves. The use of short-term unemployment2 or household inflation expectations
that are closer to those of economic agents, are two examples of promising developments. It
is also helpful to introduce time-varying coefficients or regime-switching estimates, to
account for many possible sources of non-linearity in the Phillips curve.
For headline inflation, external supply shocks, for example in commodity prices, have played
a significant role but the two highlighted puzzles also apply to core inflation. Very importantly,
the trend for a weaker relationship with economic slack applies also to core inflation. Most of
the papers I have cited use the consumer price index (CPI) without energy and food or the
GDP deflator as inflation variables. Only a few also use headline inflation. Core inflation
reflects mostly domestic factors, as indirect effects from external developments are muted
and take time to operate. That is why I consider it more useful to focus on core inflation
dynamics for the purpose of discussing their consequences for monetary policy.
Despite a few dissenters, the majority view in these papers is favourable to the idea
that the slope of economic slack has declined. There are several possible explanations:
The increased anchoring of inflation expectations makes inflation less sensitive to economic
activity.
Higher import volumes as a result of increased globalization have also increased the
importance of international prices relative to domestic prices, forcing domestic mark-ups to
be less sensitive to the state of the domestic economy.
Also as a result of globalization, inflation across countries displays an important common
factor that explains a substantial part of the national inflation variation. Ciccarelli and Mojon
(2010) and Ferroni and Mojon (2014) show that the commonality of inflation goes beyond
what can be captured by commodity prices. They also report that the global inflation factor
would improve forecasts of domestic inflation in different specifications, from augmenting an
AR (1) model to using it in Phillips curves or BVARs. Further, they demonstrate that the
importance of the common factor does not depend on spillovers among countries but is more
the result of common shocks and convergence of monetary policy frameworks around the
world. Confirming these results, Medel, Pedersen and Pincheira (2014), using a sample of 31
OECD countries, report that the global inflation factor improves the inflation forecast for 50%
of the countries in the case of headline inflation and for 40% in that of core inflation.
Nevertheless, the improvements in the forecasts mentioned in these papers are contained,
producing a 5% to 6% reduction in the root mean squared errors.
The fourth type of explanation relates to possible non-linearities in the relationship between
inflation and real activity. More precisely, the coefficient of the real activity measure in a
Phillips curve may depend on the size and duration of economic slack, on the level and
volatility of inflation, and on the degree of anchoring of inflation expectations. Specifically:
Clark, Laxton and Rose (1996) and Macklem (1997) point to the role of capacity constraints:
during recessions, when firms operate below their full capacity, if demand is successfully
stimulated, firms will be able to produce more without incentives to raise prices. During boom
times, when firms operate closer to full capacity, additional demand translates into stronger
price increases. Thus, the slope of the Phillips curve is an increasing function of excess
demand.
Ball, Mankiw and Romer (1988) and Ball and Mankiw (1994) discuss convexity of the Phillips
curve in the context of adjustment/menu costs. Ball, Mankiw and Romer (1988) show that in
a new-Keynesian framework the frequency of price changes increases when the average
rate of inflation increases, because firms must adjust their prices more frequently to keep up
with the general rise in prices. As a consequence, the slope of the Phillips curve increases
with the level of inflation.
Stiglitz (1986), Fisher (1989) and Akerlof, Dickens and Perry (1996) developed models with
downward wage and price rigidities. These models embed the fact that workers are more
reluctant to accept a decrease in their wages than an increase. At times of excess supply,
the slope of the Phillips curve becomes an increasing function of the level of inflation.
The theories that imply convexity rationalise relatively stronger expansionary monetary policy
action during times of recession (as price pressures induced by expansionary policy are
expected to be smaller during recessions).
The consequences for monetary policy of the weakening of the link between the level
of economic activity and inflation, if this weakening indeed happened, would be
significant. First, it has consequences on the sacrifice ratio: if inflation increases as a result
of shocks not related to domestic slack, then the cost of bringing inflation down in terms of
output loss would increase sharply. Second, if instead inflation becomes very low, monetary
policy would have to stimulate economic activity more strongly and could lack effective
instruments to do so. In sum, a flatter slope of the Phillips curve makes controlling inflation
either more costly or more difficult. Naturally, when that flattening is associated with more
strongly anchored expectations, the difficulties are mitigated.
What this underlines is the need to carefully monitor the relative importance of different
drivers of domestic inflation: inertia, expectations, economic slack, supply shocks and
external variables. Several methods and models are necessary for the task, as policy makers
cannot rely on the perspective provided by a single tool.
Nevertheless, the fact remains that forecasters were not able to anticipate the
disinflation for the euro area as a whole from 2012, or for the larger member countries.
This is particularly surprising because forecasters did take into account the fall in economic
activity in most euro area countries after 2011, which generated significant gaps between
actual and potential output. The ECB has not been alone in over-predicting euro area
inflation. The IMF, ECB Survey of Professional Forecasters (SPF), Consensus Economics,
Euro Zone Barometer, OECD and European Commission have also systematically
overpredicted both headline and core inflation at all horizons, especially since the second quarter
of 2012.
Figure 3
However, as policy makers we need more than just good inflation forecasts: we also
need to understand the inflation process in order to better assess the role of monetary
policy. We also need to be able to explain our reasoning to the public, as the management
of expectations has become such an important monetary policy instrument. This is one more
reason for continuing to use the Phillips curve as a tool to discuss inflation dynamics.
The current attention to the relationship between inflation and economic slack has led
to an intense debate on the stability of the Phillips curve and its power to explain the
twin puzzle. Empirical research, especially in the United States, shows that the slope of the
Phillips curve has varied over time, with a clear tendency to flatten over the years.
For the euro area, the evidence from several recent papers points to a steepening in
recent years (see e.g. Oinonen and Paloviita (2014), Riggi and Venditti (2015) and Foroni
and Porqueddu (2015)). This development is especially marked in those countries which
experienced deeper and longer recessions and made greater efforts to reform their product
and labour markets, with an impact on nominal rigidities (see, for Italy, Riggi and Santoro
(2015) and, to a lesser extent, for Spain, Banco de España (2013 and 2015). When
analysing the excessive disinflation in the euro area since 2012, natural questions arise as to
whether we are facing a new regime of low inflation (e.g. due to demographics, integration of
low-cost countries in global trade, less powerful trade unions, dominance of a service
economy), and whether the Phillips curve (and "which" Phillips curve) is still an appropriate
framework of analysis.
A number of technical issues pertaining to the Phillips curve have not yet been settled
in the literature.
A key problem in this debate is that single-equation estimates of the Phillips curve
might not correctly identify its slope, as inflation and economic slack are determined
simultaneously.
Moreover, economic slack is a multidimensional concept that is not directly
observable and choices must be made on how to estimate or measure it.
An additional problem is that inflation is also influenced by foreign shocks, either
directly via imported inflation or indirectly via global economic slack, as a consequence of
international integration of production. How do we account for such external shocks?
Further, the standard hybrid New Keynesian Phillips curve includes agents' inflation
expectations, which are also difficult to measure. Recent work by Coibion and
Gorodnichenko (2015) uses expectations from surveys, with some practical success. It
highlights that the choice of the measure of inflation expectations is crucial in understanding
inflation dynamics in the United States, advocating the use of surveys of household inflation
expectations rather than those of professional forecasters. Naturally, expectations from
surveys or professional forecasters are not microfounded. More generally, NKPC has had
many problems to predict inflation even when embedded in a DSGE model. As King and
Watson (2012) highlight when using the labour income share or unit labour costs the models
do not capture that the last 15 years do not show a co-movement of inflation with the
significant decline of those ULCs. Gürkaynak, Kisacikoglu and Rossi (2013) also illustrate the
subpar performance of DSGE models to forecast inflation. In their encompassing survey
Mavroeidis, Plagborg-Møller, and J. Stock (2014), also conclude that without rejecting the
NKPC, "we are unable to pin down the role of expectations in the inflation process sufficiently
accurately for the results to be useful for policy analysis".
Finally there is the question of stability of Phillips curve parameters, in the form of
non-linearities or structural changes. As sudden decreases in forecasting ability are
frequently associated with instability, a plausible explanation for the recent inflation surprises
is a change in the slope of the Phillips curve. In what follows I am going to show some
robustness analysis of the Phillips curve. Let us focus on slack.
Economic slack is the great unknown: it is unobservable and is highly sensitive to the
assumptions used for the decomposition of economic activity into trend and cycle.
Usual measures of slack can vary substantially across methods and variable inclusion,
although they tend to agree on the timing of peaks and troughs.
The fact that economic activity is multidimensional suggests that there might be
advantages in using large dynamic models to estimate it. For instance, ECB staff used a
dynamic factor model that performs a trend/cycle decomposition of real activity variables and
core inflation3 The model uses a single factor to capture common cyclical fluctuations and
estimates the output gap as the deviation of output from its trend. Different modelling
assumptions, such as different sets of real activity indicators and different specifications of
the trend components of the variables, lead to different estimates of the output gap. These
differences are economically very relevant, with some models estimating an output gap that
was close to zero in 2014 on average, and others estimating remaining slack of as
much as -6%.
One way to discriminate among different estimates of the output gap is to check their
ability to forecast inflation. It turns out that the variants associated with a continuation of a
positive growth trend, implying a wider output gap, are the ones that produce better inflation
forecasts. The best variant from this perspective implies that the output gap was as large as
-6% in 2014 (see the left-hand chart of Figure 4). Assuming the opposite, namely a break in
the output trend, which we could call a secular-stagnation hypothesis, leads to a much
poorer forecast ability of recent inflation. The output gap estimated by the IMF and the
European Commission are halfway between the extremes arising from the dynamic factor
model I have described (see right-hand chart of Figure 4).
Figure 4
Taking into account uncertainty over how to measure slack and inflation expectations,
the Phillips curve is alive and well in the euro area (in some form). The dynamic factor
model just discussed is not the only one that can explain the recent excessive disinflation.
ECB staff have conducted a specification search with a hybrid NKPC using different
measures of slack and of inflation expectations, and also including import prices as a
measure of external shocks.
Figure 5
Several specifications are indeed able to track the recent disinflation. The results are
shown in Figure 5, where each grey line is the conditional out-of-sample projection of
inflation excluding energy and food, based on its own lag, lagged import prices, a measure of
slack (lagged) and a measure of inflation expectations. The projection is based on the
realized values of the explanatory variables except for lagged inflation, which is determined
dynamically. While indeed many models pointed to inflation increasing faster than it did,
some are able to track the disinflation quite well. These models tend to be those that use the
unemployment rate (or gap) and a short to medium-term measure of inflation expectations.
The result holds also for conditional forecasts that start earlier, through the financial
crisis and since the first recovery. In fact, the best specifications of the same hybrid NKPC
were evaluated by looking at out-of-sample dynamic projections of inflation over the period
up to end-2014 based on two different estimation samples, one ending in 2007 and the other
in 2009. Figure 6 shows that the results are satisfactory for both exercises.
Figure 6
However, as I have already hinted, the coefficients of the Phillips curve may not be
stable. As I mentioned above, the slope of the Phillips curve might have increased over the
period when we were over-predicting inflation. Running the same specifications just
described over two samples, one stopping at 2012 Q1 (when we started to systematically
over-predict inflation excluding food and energy) and the other covering the full sample
ending in 2014 Q4, there is some evidence of an increase in the slope estimate. This
suggests the specific possibility of non-linearities that could be due to state-dependency of
the Phillips curve or to structural change of some form. Indeed, regime-switching estimates,
accounting for parameter change due to state-dependency on various measures of the
business cycle can help to explain the "excessive" disinflation since 2012. The results are
shown in Figure 7 below.
Figure 7
How much time variation is there in the slope of the Phillips curve, and in which
direction? The discussion on the steepening or flattening of the Phillips curve brings me to
recent discussions that pointed to a flattening, particularly for the United States, but also for
various other advanced economies. Let us take an agnostic view on the origins of the
timevariation (that is, without necessarily making it conditional upon regimes identified by a
specific variable) and estimate a hybrid NKPC with time-varying parameters, similar to that in
Blanchard et al. (2015). Over the sample period running from 1999 Q1 to 2015 Q2, the slope
of headline inflation had a general tendency to decrease until 2011, after which it rebounded
(see the left-hand chart in Figure 8). For core inflation the upward shift started earlier (see
the right-hand chart in Figure 8). This is true for the euro area as a whole but particularly
valid for some countries that experienced longer recessions and made greater efforts to
reform their product and labour markets with an impact on nominal rigidities.
Figure 8
Some variation is also visible in the estimates of the other parameters, with the weight on
expectations increasing over most of the 2000s relative to the level of persistence, and the
effect of the exchange rate, but not relative to the level of import prices in US dollars, which
slightly increased over time.
Figure 9
The impact of the change in the central parameter estimates on conditional
predictions is not negligible. Indeed, estimating this model with constant and with
timevarying parameters and feeding it with technical assumptions based on the June ECB staff
macroeconomic projections for import prices, exchange rates and the measure of slack (i.e.
the unemployment rate, as the gap is estimated endogenously within the model), as well as
for projected inflation expectations, yields a significantly steeper profile for inflation excluding
food and energy over the next two-and-a-half years (Figure 10). The steepening of the
Phillips curve also helps improve its ability to fit the low inflation episode, together with the
use of measures that indicate wider negative slack and short- to medium-term survey
inflation expectations.
Figure 10
Conclusions
Inflation dynamics since the Great Recession have shown signs of instability that have led to
a sequence of systematic forecast errors. The two puzzles of "missing disinflation" and
successive "excessive disinflation" triggered a surge of new research around the Phillips
curve and its possible demise, which seems to have been prematurely foretold.
There is an important common factor in inflation in the advanced economies that helps
explain national inflation dynamics. The current phase of low inflation, aside from commodity
price developments, is significantly influenced by negative demand shocks both at the global
and national level.
In particular, the recent low inflation in the euro area was largely triggered by domestic
demand weakness, which probably led to a larger degree of economic slack than was
predicted by the usual methods.
The Phillips curve seems to survive the recent reassessment and is still a valid tool of
analysis in the euro area, meaning that a sustained recovery in inflation is conditional upon
real activity and inflation expectations.
The link between inflation and real activity appears to have strengthened in the euro area
recently. Provided our policies are able to significantly reduce the output gap, we can rely on
a material effect to help bring the inflation rate closer to target.
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