Euro area inflation steepens Phillips curve, boosts policy impact
A Banca d'Italia working paper finds that the recent surge in euro area inflation led firms to adjust prices more frequently. This shift temporarily steepened the Phillips curve, enhancing the effectiveness of monetary policy in containing cost-push shocks.
Price adjustments reshape inflation dynamics
Firms in the euro area significantly increased the frequency with which they adjusted prices during the 2021-22 high-inflation surge.
This shift in price-setting behaviour led to a transitory steepening of the Phillips curve, which had remained persistently flat throughout the preceding low-inflation period.
In a model with nominal rigidities, a higher frequency of price adjustments steepens the Phillips curve and enhances the transmission of monetary policy, enabling central banks to contain cost-push shocks with a smaller loss in output.
The paper provides robust empirical evidence for the euro area using panel local projections, confirming the link between the frequency of price changes, the slope of the Phillips curve, and the increased effectiveness of monetary policy.
The analysis delivers findings that the slope of the euro-area Phillips curve varies sharply across macroeconomic episodes, rejecting a stable inflation-slack relationship.
From low inflation to energy shock
The euro area experienced distinct inflation regimes: stable pre-Global Financial Crisis, prolonged low inflation post-crisis, and a sharp increase after the COVID-19 pandemic and the 2021-22 energy crisis.
Inflation peaked above 10 percent in autumn 2022 before declining rapidly with modest impact on activity.
Cost-push shocks, particularly energy prices and supply-chain disruptions, primarily drove inflation, prompting rapid price adjustments.
The paper's model suggests that cost-push shocks raise both inflation and price adjustment frequency, strengthening monetary policy transmission and lowering the sacrifice ratio.
This implies that monetary policy shocks have larger disinflationary effects when energy price inflation is high.
A timely re-evaluation of policy tools
This research offers a crucial re-evaluation of the Phillips curve's relevance in a high-inflation environment, challenging assumptions of its persistent flatness.
The finding that monetary policy transmission strengthens with increased price flexibility provides central banks with a more nuanced understanding of their tools.
However, the 'transitory' nature of this steepening suggests that policymakers cannot rely on this enhanced effectiveness indefinitely.