Eurozone inflation differentials and the ECB
This paper presents new evidence on inflation differentials in the Euro Area from different perspectives, and extending the sample including the recent financial crisis. First, we give an informal analysis of the evolution of inflation dispersion and inflation differentials since the start of EMU. Second, we perform formal statistical analyses of the stability properties of inflation differentials in the period 1999-2010. Univariate and multivariate tests reject the null of stability of inflation differentials when conducted over the entire sample period. However, when the financial crisis is excluded, the null of stability is not rejected for the large majority of countries. This finding implies the beginning of a new tendency since the global financial turmoil, and new challenges for the common monetary policy. Finally, we analyze the determinants of inflation differentials, empirically testing a number of theories including price level equalization, productivity differentials, differences in cyclical positions, labor and product market rigidities. We conclude that inflation differentials are not the result of equilibrating, transitory forces, but rather of persistent structural and country-specific factors. This calls for structural reforms in labor and product markets, and countercyclical fiscal policy measures at the individual country level. As inflation differentials pose a serious challenge for the monetary policy of the ECB, we further believe that the ECB should be equipped with additional policy instruments to cope with them in a more direct way.
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