The role of expectations in euro area inflation dynamics

This paper examines empirical performance of three different Phillips curve specifications in the euro area. Instead of imposing rational expectations, direct measures, ie OECD forecasts, are used to proxy economic agents’ inflation expectations. Real marginal costs are measured in three different ways. The results suggest that with directly measured expectations the estimated New Classical Phillips curve has satisfactory statistical properties. Moreover, the driving variable enters the estimated, purely forward-looking, New Keynesian Phillips curve with the correct sign, but it is clearly outperformed by the New Classical and Hybrid Phillips curves. We interpret our results as indicating that the European inflation process is not purely forward-looking, so that inflation cannot instantaneously adjust to new information. Consequently, even allowing for possible non-rationality in expectations, a lagged inflation term enters the New Keynesian Phillips curve for European inflation dynamics. The inflation process seems to have become more forward-looking in the recent years of low and stable inflation. Furthermore, in the New Keynesian Phillips curve relationship, the output gap turns out to be at least as good a proxy for real marginal cost as is the labour income share.