vitor constancio : understanding inflation dynamics and monetary policy in a low inflation environment remarks by mr vitor constancio, vice - president of the european central bank, at the ecb conference on “ challenges for macroeconomic policy in a low inflation environment ”, frankfurt am main, 5 november 2015. * * * this speech is partially based on the speech delivered at the jackson hole economic policy symposium 2015. introduction ladies and gentlemen, at the beginning of this conference, i wish to extend a warm welcome to all participants, thanking everyone for collaborating with this ecb initiative. in my remarks today i will discuss a few issues related to understanding inflation dynamics, focusing on recent developments in euro area inflation and their implications for monetary policy. several conference papers make important contributions both to the analysis of the causes and consequences of low inflation, and to the design of policy responses. understanding inflation dynamics is especially important today due to the very low inflation levels prevailing in many countries. moreover, there are studies suggesting that in some countries the relationship between slack in the economy and inflation seems to have weakened recently. if confirmed, this weakening of the link between the level of economic activity and inflation would have significant consequences for monetary policy. first, it has important implications for the sacrifice ratio : if inflation rises as a result of shocks not related to domestic slack, then the cost of bringing inflation down in terms of output loss would be higher. 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, given the zero lower bound ( zlb ) on nominal interest rates. in sum, a flatter slope of the phillips curve would make controlling inflation either more costly or more difficult. in this context, a surprising development is the emergence, of a “ twin puzzle ” after the great recession : first, “ missing disinflation ” from 2009 to 2011, and second, “ excessive disinflation ” after 2012, particularly in europe. during the great recession, inflation in advanced countries did not fall as much as a traditional phillips curve predicted, given the severity and length of the recession. just as puzzling, more recent global developments point in the opposite direction. namely, despite the ongoing recovery, headline inflation rates in advanced economies remain well below target. the seemingly weakened relationship between inflation and economic slack seems to have made interpreting and controlling inflation dynamics more difficult. i will try to convince you that if one looks deeper this is not necessarily the

adjustment in unit labour costs and the adjustment in the harmonised index of consumer prices ( hicp ) reflects the lack of competition in the domestic economy. it also reflects other cost factors affecting the evolution of prices, including fiscal consolidation being partly achieved through higher indirect taxes and administrative prices. 5 it calls for great determination in reducing the excessive profit margins that result from monopolistic competition, in particular in sectors sheltered from international competition. 6 reducing rents is not only a matter of efficiency in the adjustment process : it is also a matter of equity in sharing the burden of adjustment. and this point leads me to the second part of my talk. the aggravating factors [ slide 7 ] the adjustment has been costly, in some cases very costly. some of the costs in terms of falling output and employment were, unfortunately, unavoidable. in particular, some of the job losses in the non - tradable sector are the outcome of the necessary rebalancing towards tradables and away from previously unsustainable domestic demand growth. however, the rise in unemployment in a number of countries has been aggravated by delays in structural reforms and, as i said, by a lack of downward flexibility in prices and wages after 2008. job losses were largest among low - skilled, temporary workers in spain and in the non - manufacturing sectors. 7 as employment fell, unemployment – particularly of the young – jumped, especially in greece and spain, where more than a quarter of the total labour force is currently without a job. there was also a sharp increase in unemployment in the baltic states – it rose from 5 % in 2007 to 18 % in 2010 on average in estonia, lithuania and latvia. however, since 2010 in all three countries unemployment has fallen relatively quickly. by the end of 2012 it had improved by about 10 percentage points. 8 in the most stressed euro area countries, there are no signs of a reversal yet. this is the result of the inherited very rigid product and labour markets, which have started to change and need to continue to do so vigorously to prevent further job losses. again, this is not only a matter of efficiency, but also a matter of equity. europe cannot afford a lost generation. see ecb monthly bulletin box ( 2012 ), rebalancing of competitiveness within the euro area and its implications for inflation, june 2012, pages 64 – 66. the higher profit margins of the past two years need to be interpreted carefully as they in part represent a rebound after