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© 2022 International Monetary Fund
WP/22/260
IMF Working Paper
European Department
A Bottom-Up Reduced Form Phillips Curve for the Euro Area Prepared by Thomas McGregor and Frederik Toscani
Authorized for distribution by Oya Celasun
December 2022
IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
ABSTRACT: We develop a bottom-up model of inflation in the euro area based on a set of augmented Phillips curves for seven sub-components of core inflation, and auxiliary regressions for non-core items. The disaggregated structure of the model improves on the forecasting performance of a standard one-equation Phillips curve, especially since the onset of the Covid-19 pandemic in early-2020 and the following energy shocks. We find a key role for international energy and food prices in explaining the recent surge in inflation – as of Q2 2022, they account for 75 percent of the increase in headline inflation and 30 percent of the increase in core. Economic slack and inflation expectations explain another 10 percent of headline and 20 percent of core inflation. Around one-third of the increase in core inflation remains unexplained by the model. Out of sample projections show high uncertainty around the inflation path while suggesting that inflation pressures are unlikely to dissipate quickly. We argue that the bottom-up approach offers a useful complement to the forecaster’s toolbox–especially in the current environment of sectoral shocks – by improving forecast accuracy, shedding additional light on the drivers of inflation, and providing a framework in which to apply ex-post judgement in a structured way.
RECOMMENDED CITATION: McGregor, T. and F. Toscani (2022), “A Bottom-Up Reduced Form Phillips Curve for the Euro Area”, IMF Working Paper WP/22/260.
| JEL Classification Numbers: | E31; E37; C32 |
| Keywords: | Euro area; Inflation; Phillips curve |
| Author’s E-Mail Address: | tmcgregor@imf.org; ftoscani@imf.org |
| JEL Classification Numbers: | E31; E37; C32 |
| Keywords: | Euro area; Inflation; Phillips curve |
| Author’s E-Mail Address: | tmcgregor@imf.org; ftoscani@imf.org |
Title Page
WORKING PAPERS
A Bottom-Up Reduced Form Phillips Curve for the Euro Area
Prepared by Thomas McGregor and Frederik Toscani1
Contents
EXECUTIVE SUMMARY
I. INTRODUCTION
II. METHODOLOGY
A. The Harmonized Index of Consumer Prices (HICP) Basket
B. The Canonical Phillips Curve
C. An Important Aside on Economic Slack
D. Baseline Bottom-Up Model Specification
III. REGRESSION RESULTS
IV. FORECASTING PERFORMANCE
A Practical Considerations
A. Overall
B. Pre-Pandemic Period vs 2020–2022
C. What explains the increase in forecast errors?
V. THE DRIVERS OF INFLATION
A Impact of Standardized Changes in Explanatory Variables
B. Decomposing the Drivers of the Recent Inflation Surge
VI. PROJECTING INFLATION
A The role of model uncertainty
B. Scenario Analysis
VII. CONCLUSION
ANNEX I
REFERENCES
The authors would like to thank Ravi Balakrishnan and Nir Klein for their guidance on the project. Staff of the IMF provided helpful comments via the internal review process and during various surveillance meetings; and staff of the European Central Bank provided useful suggestions and feedback at several stages of the project, including during a presentation at the ECB in Frankfurt. We also thank seminar participants at the European Commission in Brussels. Projections shown in this paper are illustrative to present the working of the model. They do not reflect the latest projections of the IMF or IMF staff.