What inflation developments reveal about the Phillips curve: implications for monetary policy

Average inflation in the euro area has remained relatively stable since the onset of the current economic and financial crisis. Given the extent and length of the crisis, this observation might seem surprising in that it suggests that the traditional cyclical behaviour of inflation has weakened over time. The article seeks to determine the factors that explain this apparent change in inflation dynamics. To this end, the authors estimate a Phillips curve with time-varying parameters for the euro area using Bayesian techniques. The estimation results suggest that the observed stability of inflation is due to a combination of a flattening of the Phillips curve and increasing sensitivity of inflation to long-run inflation expectations, which have appeared firmly anchored in the euro area. These developments may have implications for the conduct of monetary policy. For instance, the better anchoring of current inflation to long-term expectations suggests that the traditional interest rate channel of monetary policy has become more effective. Furthermore, the findings of the article have implications for the inflationary effects of demand and supply shocks hitting the economy, thereby underscoring the need for an in-depth analysis in order to make appropriate monetary policy decisions.