Inflation dynamics in the euro area and the role of expectations: further results

This paper examines the empirical performance of the New Keynesian Phillips curve and its hybrid specification in the euro area. Instead of imposing rational expectations, direct measures, ie OECD forecasts, are used as empirical proxies for economic agents´ inflation expectations. Real marginal costs are proxied by three different measures. The results suggest that OECD inflation forecasts perform relatively well as a proxy for inflation expectations in the euro area, since under this approach the European inflation process can be modeled using the forward-looking New Keynesian Phillips curve. However, inflation can be modeled even more accurately by the hybrid Phillips curve. Thus, even allowing for possible non-rationality in expectations, the additional lagged inflation term is needed in the New Keynesian Phillips relation. In this approach, the output gap turns out to be at least as good a proxy for real marginal costs as the labor income share. Moreover, the inflation process seems to have become more forward-looking in the recent years of low and stable inflation.