ECB study reveals state-dependent inflation-output relationship

An ECB working paper reveals significant state-dependent asymmetries in monetary policy transmission and Phillips curve parameters across four economic regimes.

The study, using a nonlinear model, defines these regimes by joint deviations of inflation from target and output from potential: inflationary boom, disinflationary boom, inflationary slack, and disinflationary slack.

Key findings indicate that the Taylor principle, which ensures real interest rates rise with inflation, holds consistently across all four regimes.

However, the systematic policy response to the output gap weakens when inflation is below target but output remains above potential.

Conversely, the size of monetary policy shocks is significantly larger when inflation exceeds its target, reflecting the Federal Reserve's focus on high inflation.

The Phillips curve steepens during inflationary booms, where inflation exceeds target and output is above potential, making demand and monetary policy shocks more pronounced.

The sensitivity of the output gap to interest rate changes declines when elevated inflation coincides with economic slack, leading to less effective monetary policy transmission in such periods.

The study highlights the limitations of traditional linear models, which assume constant relationships between economic variables.

This nonlinear approach offers a more nuanced understanding of monetary policy operation and shock transmission.

These insights are highly relevant for policymakers, as policy effectiveness varies critically with the economic regime.

For instance, restrictive monetary policy effectively reduces inflation during inflationary booms, but its impact may be more limited during inflationary slack.

This suggests a need for stronger determination to combat inflation in specific economic states.