Revisiting the Eurozone Phillips curve |
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| Abstract: | - In a recent speech, ECB chief economist Peter Praet emphasised the importance of the Phillips curve ‐ the inverse relationship between unemployment and inflation ‐ when addressing concerns that disinflation (or even deflation) could become a longer‐term problem in the Eurozone. Praet argued that a scenario of a sustained period of disinflation is only realistic if the link between economic slack and inflation is broken. In this article, we revisit the Phillips curve in the Eurozone with the aim of gauging whether there has been a change in the relationship following the global financial crisis and how uniform the curve is among major Eurozone economies.
- We conclude that the Phillips curve is still valid in the Eurozone, although our analysis indicates a weakening of the link in the post‐crisis period. On the whole, our analysis shows that the Phillips curve relationship has been robust in the Eurozone since the creation of the currency union. However, in replicating the analysis for just the pre‐crisis period, we have noticed that the relationship between slack and inflation for the Eurozone was stronger (i.e. the slope of the curve was steeper) before the crisis rather than over the whole sample, since the introduction of the Euro.
- We find that there is considerable heterogeneity in the strength of the link between inflation and slack across the Eurozone economies, which adds to our existing body of work on their different responses to same shocks. Moreover, in contrast to the Eurozone overall, we find that in Spain and Italy the responsiveness of inflation to slack appears to have actually increased since the crisis; this might reflect the effectiveness of the structural reforms undertaken in both countries in order to reduce the rigidity of their economies.
- From 2014 onwards, very low inflation in the Eurozone has led to fears of sustained disinflation and even a deflationary spiral. Our view has always been that these fears were overblown; proving that the key structural relationship needed for ECB to meet its mandate is still in place corroborates our stance. Our forecast is for headline inflation to rise to 0.7% in 2016 (under the assumption that oil prices average US$37pb) and then to 1.7% in 2017 ‐ in line with ECB's target of “close to, but below, 2%”. The Phillips curve we have derived for the Eurozone tells a similar story. However, renewed weakness in oil prices at the start of 2016 presents a downside risk to our forecasts.
- Our bottom‐up CPI inflation model indicates that inflation might average just 0.2% this year if oil remains at around US$30pb. Furthermore, the prospect of external demand weakness derailing the Eurozone recovery poses another risk. This has raised the possibility of further expansion of the ECB's QE programme. However, as we continue to see resilient domestic demand in 2016, our baseline case still remains that the ECB will make no additional substantial adjustments to its QE programme in the near term.
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