The inflation puzzle in the euro area

The inflation puzzle in the euro area – it’s the trend not the cycle!

What’s happening to inflation and output in the euro area? The ECB has apparently lost the opportunity to raise inflation and price expectations have already been sliding because the last recession. A lot of the policy debate has centered on the flattening of the Phillips curve. Yet, as this column shows, estimations of the joint output-inflation process indicate a decline of both output potential and trend inflation as the utmost relevant components of the puzzle.


The most recent ECB projection for headline inflation (HICP) points to a sharp downward revision of what forecasted 2 yrs ago (ECB 2017, 2019). For instance, this season inflation was projected to be 1.5% although it is currently estimated to be at 1.2%. The corresponding numbers for 2020 are 1.7% and 1%, respectively.

In January 2018 we wrote a Vox column where we forecasted euro area headline inflation to be 1.1% this season and to remain near 1% for another five years. That forecast was predicated on our semi-structural model for all of us inflation (Hasenzagl et al. 2018a) adapted to match euro area data. At that time we were a lot more pessimistic compared to the ECB’s own forecasts however in line with market expectations (Hasenzagl et al. 2018b)

In this column we ask two questions. First, with the advantage of almost 2 yrs of additional data, has our view changed? Second, what does the answer imply for our estimates of the Phillips curve and the output gap in the Union?

The response to the first question is negative. Our forecast because of this year is consistent with what predicted 2 yrs ago and points to at least one 1.48% for Q4-2022. That is near what the ECB projects for 2021.

Figure 1 Quarterly year-on-year HICP inflation and forecasts

Notes: Forecast period, indicated with a shaded area, is Q4-2019 to Q3-2023. The red line shows the authors’ prediction conditional to the word structure of oil futures prices.
Sources: ECB, ECB SPF, Eurosystem, EZ Barometer, Consensus Economics and authors’ calculations.

To answer the next question, we can utilize the model to secure a coherent view. Indeed, our framework produces estimates of several structural estimates – potential output, the output gap, the Okun law, a power price cycle – and decomposes inflation right into a cycle explained by the Phillips curve connecting the output gap to prices, a power component linked to oil prices, and its own trend that is defined as the long-term inflation expectation.

Figure 2 reports our estimate of the output gap against the IMF, European Commission and Bloomberg estimates and Figure 3 our rate of growth of potential output (trend output).

Figure 2 Output gap as percentage of potential GDP for the euro area

Sources: Bloomberg, IMF, European Commission – all annual data interpolated at quarterly frequency – and authors’ calculations.

Figure 3 GDP growth and potential output growth (annualised) for the euro area

Note: Potential output growth may be the (one-sided) four-quarters moving average of the annualised GDP trend growth.
Source: authors’ calculations.

Our way of measuring the output gap is fairly correlated with institutional measures. It implies an adaptive trend which ultimately shows a steady decline because the beginning of our sample in the mid-eighties and yet another persistent slowdown because the Global Crisis (potential growth is currently estimated to be at 1%). The latter, good view that deep recessions create hysteresis in real economic activity (e.g. Galì 2015), we attribute the slowdown of average output growth because the crisis to the trend instead of to the cycle. This view can be supported by the observation that the 2008 recession is connected with a persistent fall in private investment, which reaches odds with past business cycle regularities (Caruso et al. 2019).

Our model implies a comparatively steep Phillips curve if when compared to literature’s estimates that find that it has weakened as well as disappeared (e.g. Ball and Mazumder 2011, IMF 2013, Hall 2013). However, because the output gap is relatively small and, currently, energy price includes a neutral influence on headline inflation, the existing dynamics of inflation is mainly explained by its trend. Figure 4 reports the decomposition of the cyclical element of HICP inflation into energy (red), business cycle (blue) and noise (yellows) and makes the idea.

Figure 4 Quarterly year-on-year CPI cycle, historical decomposition

Note: Forecast period is indicated with a dashed line, and goes from Q4-2019 to Q1-2024.
Source: authors’ calculations.

This view of the euro area macroeconomic dynamics could be summarised the following.

We still have a positive output gap which is near peak (first quarter of 2020) and the economy is currently expected to go back to trend growth which is estimated to be about 1%. Inflation decline is mainly to be related to its trend component, which we identify as long-term expectations. The Phillips curve, although steep, contributes little upward pressure because the decline of output growth is in largely because of a downward adjustment of output potential.

Although a lot of the policy discussion has centered on the Phillips curve and the economic cycle, what has to be understood will be the trends. That is true for both output and inflation.

For policy implications, the idea of attention in the euro area ought to be the fact that inflation expectations (the trend) have already been declining since early 2014 and, notwithstanding some volatility, is likely to remain less than target for years. Delayed monetary policy action in 2012-2014 maybe a conclusion. Interestingly, our US estimates indicate an increased inflation trend (Hasenzagl et al. 2018b) which can be supported by the dynamics the inflation expectations at five-year horizons by professional forecasters, as reported in Figure 5.

Figure 5 Survey of professional forecasters for the united states and the euro area at five-year horizons (mean)

A fascinating venue for reflection may be the understanding of the normal factors behind declining trend output growth and trend inflation. Legacy debt and risk aversion, which will be the consequence of the Global Crisis, together with uncertainty linked to a deep transformation of our economies, from climate change to technology to ageing, may weight on both output and inflation in a persistent way. This demands non-standard monetary and fiscal policy addressing nominal GDP trends.

Note also that the same forecast of inflation might have been obtained by a model with a more substantial output gap (and steeper GDP trend) but a flatter Phillips curve (e.g. Jarociński and Lenza, 2018). Therefore, the question accessible isn’t how steep the Phillips curve is really but whether we have confidence in a global with a steep Phillips curve and declining potential output growth, or in a global with a set Phillips curve and constant potential output growth.


Ball, L, and S Mazumder (2011), “Inflation Dynamics and the fantastic Recession”, Brookings Papers on Economic Activity 42(Spring): 337-381.

Caruso, A, L Reichlin and G Ricco (2019), “Financial and Fiscal Interaction in the Euro Area Crisis: THIS TIME AROUND was Different”, European Economic Review 119: 333-355.

Galí, J (2015), “Hysteresis and the European unemployment problem revisited”, ECB Forum on Central Banking, May.

Hall, R E (2013), “The Routes Into and Out of your Zero Lower Bound”, paper presented at the “Global Dimensions of Unconventional Monetary Policy” Federal Reserve Bank of Kansas City Symposium, Jackson Hole, Wyoming.

Hasenzagl, T, F Pellegrino, L Reichlin, and G Ricco (2018a), “Low inflation for longer”,, 15 January.

Hasenzagl, T, F Pellegrino, L Reichlin and G Ricco (2018b), “A Style of the Fed’s Take on Inflation”, CEPR Discussion Paper No. 12564.

IMF (2013), “YOUR DOG that Didnt Bark: Has Inflation Been Muzzled or Was It Just Sleeping?”, Chapter 3 hoping, Realities, Risks. World Economic Outlook, April.

Jarociński, M and M Lenza (2018), “An Inflation‐Predicting Way of measuring the Output Gap in the Euro Area”, Journal of Money, Credit and Banking 50(6): 1189-1224.

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