Asymmetries in the relationship between inflation and activity

Studying changes in the way inflation responds to fluctuations in activity and the possible dependence of this response on the course of the business cycle is of interest as this sensitivity is a key factor in the monetary policy transmission mechanism. Analysing price flexibility is also fundamental to determining the extent to which adjustments to shocks affecting an economy have an impact on activity and employment. Since the introduction of the common currency, inflation in the Spanish economy has behaved in a way that clearly differs depending on the course of the business cycle. Thus, during periods of expansion, demand pressures have caused inflation rates averaging over 2%. The recession that began in 2008 translated into a substantial slowing of the pace at which consumer prices rose in the Spanish economy, with inflation dropping well below 2%, even after stripping out the impact of cheaper oil prices. Consequently, the increase in the CPI excluding unprocessed food and energy prices, corrected for changes in indirect taxation and regulated prices, averaged less than 0.5% in the periods of recession. The slowing of the Spanish inflation rate during the recession is partly explained by the contraction of aggregate demand, although inflation can also be seen to be more sensitive to changes in activity [see Álvarez and Urtasun (2013) and Banco de España (2015)]. This increase in the elasticity of inflation to the degree of slack in the economy is consistent with a reduction in nominal rigidities during periods of crisis, which manifests itself in more frequent price adjustments than in the past. The information from the Banco de España’s survey on wage and price formation offers evidence of this [see Izquierdo and Jimeno (2015)]. According to the survey, the lower nominal rigidity would be mainly attributable to greater variability of demand and a higher level of market competition, together with more frequent price changes by competitors. Most recent empirical evidence from other European economies also suggests that inflation is more sensitive to the point in the business cycle [see Oinonen and Paloviita (2014) and Riggi and Venditti (2015)]. By contrast, a significant number of recent studies on the economy of the United States show inflation to be less sensitive to changes in activity [see Matheson and Stavrev (2013), IMF (2013)]. Moreover, survey data suggest asymmetries exist in the way inflation responds to activity. Thus, Álvarez and Hernando (2007) find that Spanish firms respond more to the falling demand typical of recessions than to increases in expansionary periods. Although this evidence seems to suggest that inflation behaves differently over the course of the economic cycle, there is a shortage of formalised analysis considering this feature. In general, the literature assumes that inflation’s response to activity remains constant, regardless of the point in the cycle. Nevertheless, it is worth exploring the extent to which inflation responds differently in different business cycle phases, and it is also pertinent to assess whether the behaviour of inflation during the current recovery differs from that in other expansionary phases. In this context, this article describes empirical specifications of the relationship between inflation and output that allow the response of prices to changes in activity to be assymmetric over expansionary and recessionary phases, as suggested by Chart 1. Specifically, in the second section various estimates of asymmetric Phillips curves are presented that take into account the effect of inflation expectations on current inflation. The article ends with some concluding remarks.