Inflation Dynamics in the Euro Area and the Role of Expectations

This paper examines the empirical performance of the New Keynesian Phillips curve and its hybrid specification in the euro area. Instead of imposing rational expectations, direct measures, i.e. OECD forecasts, are used as empirical proxies for economic agents’ inflation expectations. Real marginal costs are proxied by three alternative measures. The results suggest that once the rational expectations hypothesis is relaxed and directly measured expectations are used, the European inflation process can be modeled using the forward-looking New Keynesian Phillips curve. However, when allowing for possible non-rationalities in expectations, inflation can be modeled more accurately by the hybrid Phillips curve with the additional lagged inflation term. In this approach, output gap turns out to be at least as good as labor income share as a proxy for real marginal cost. Moreover, the inflation process seems to have become more forward-looking in the recent years of low and stable inflation.The views expressed are those of the author and do not necessarily reflect the views of the Bank of Finland. Special thanks are due to the editor, two anonymous referees, Juha Tarkka, Jouko Vilmunen and Matti Virén for useful comments. I am also grateful to David Mayes and Geoffrey Wood for helpful suggestions and to Heli Tikkunen for excellent research assistance. For their constructive comments, I would also thank participants in the conference on the Eurosystem Inflation Persistence Network at the ECB, which was held in Frankfurt in December 2003.