Eurozone soft landing depends on Phillips curve – Schnabel

The eurozone’s hopes of returning to the 2% target without a major economic downturn depend heavily on the shape of the underlying Phillips curve, or curves, Isabel Schnabel said on August 31.

The European Central Bank executive board member noted, however, that judging the evidence is not a straightforward task.

She told a conference in Frankfurt that not only does the slope of the curve vary over time, but there also appear to be different curves in different sectors of the economy and different countries.

An ideal scenario for the ECB would be for the disinflation process to take place on the steep part of the Phillips curve. That would imply inflation could fall relatively rapidly without a large increase in unemployment.

Some evidence points in this direction, Schnabel noted. Recent research highlights how a rapid rise in marginal cost can translate into a steeper curve, as firms raise their prices more frequently.

“This is what we have seen over the past two years,” Schnabel said. “As the energy shock hit the euro area and marginal costs increased at a pace not seen since the oil price shocks of the 1970s, the share of goods and services seeing price increases rose sharply.”

However, she added there is often an “asymmetry between positive and negative cost-push shocks”. Firms are quick to raise prices when their input costs go up, but are more reluctant to pass on savings to consumers when prices fall.

“One takeaway, therefore, is that a micro-founded Phillips curve based on marginal costs rather than the output gap can help explain the surge in inflation,” Schnabel said. “But such a curve would likely point to price pressures fading more gradually.”

More evidence – possibly contradicting this hypothesis – comes from the labour market. Schnabel cited another recent research paper, presented at the conference where she spoke, which argued the Phillips curve is non-linear, at least in the US.

Pierpaolo Benigno and Gauti Eggertsson find that at low levels of unemployment, the curve steepens. This can explain the sudden surge in inflation in the US in recent years, and also implies that disinflation could be relatively rapid and not too costly in terms of job losses.

Schnabel noted the eurozone has structurally higher unemployment than the US. However, she added that the shape of a Phillips curve with the ratio of vacancies to unemployed workers “looks strikingly similar” to the US curve. The eurozone may therefore be on the steep part of the curve.

How the eurozone’s Phillips curves behave in the coming months will be a crucial factor for the ECB’s policy-making. Schnabel said the uncertainty over the outlook was a key reason the ECB governing council is taking a “data-driven” approach, rather than committing to a path of policy or a particular endpoint.

She also argued the environment called for “robust” policy. “To ensure robustness, we will need to consider not just the baseline scenario for the inflation outlook but the entire distribution of risks,” she said.

Upside risks include the effects of climate change, which are not only impacting food production and tourism, but also driving investment demand among eurozone firms, many of whom are working to decarbonise their operations. Green investment may cut prices in the longer term, but is likely to raise them in the short term. Other risks include higher labour costs, firms wielding more pricing power and fresh supply shocks.

But downside risks could also dominate. The lagged effects of monetary tightening could “unfold more forcefully” than expected, Schnabel noted. Fixed-rate mortgages have insulated many households from rate rises, but this effect will not last forever.

Depending on the data, the ECB could pause at its next policy meeting or raise the policy rate, Schnabel said. “Ultimately, the incoming data may well prescribe holding rates at restrictive levels over a significant period of time,” she added.