Failing to Forecast Low Inflation and Phillips Curve Instability: A Euro-Area Perspective

Professional forecasters failed to anticipate the sharp fall in inflation in the euro area in 2013-2014. We investigate whether this forecasting failure can be partly attributed to a break in the elasticity of inflation to the output gap. Using structural break tests and time-varying parameter models, we find that this elasticity has indeed increased substantially in the past 2 years. We offer two (observationally equivalent) interpretations of this result. The first is that the increase in the cyclicality of inflation has stemmed from lower nominal rigidities or weaker strategic complementarities in price setting. A second possibility is that current output gap estimates are understating the amount of spare capacity in the economy. We estimate that, in order to reconcile the observed fall in inflation with the historical correlation between consumer prices and the business cycle, the output gap should be wider by around one third.