Analysing euro-area inflation using the Phillips curve

This section reviews recent inflation developments and discusses the short-term outlook for inflation using a simple open-economy New Keynesian Phillips curve (NKPC). We first estimate the NKPC with time-varying parameters to analyse whether any longer-term changes could be detected in the relationship between inflation and its determinants. We then provide short-term inflation projections for the euro area and discuss the level of uncertainty surrounding these projections. Our results suggest that the sensitivity of euroarea inflation to the output gap may have increased since 2007. It remains unclear, however, whether this implies a structural change in the relationship between inflation and output. Looking ahead, projections obtained using the NKPC support the view that we are going to see a prolonged period of subdued inflation in the euro area. Annual inflation is projected to slowly start accelerating only towards the end of 2014. Based on the historical variance of the parameters of the NKPC, our assessment of the uncertainty surrounding the projection suggests that the probability of euro-area inflation turning negative over the next two years is small, while the probability of inflation rising to significantly above 2% is close to negligible.