Eurozone inflation and output do move in step, says IMF working paper

A new IMF working paper says a relationship between inflation and output in the euro area can be found "at business cycle frequencies", even if it is not apparent at first sight.

In Inflation and Output Comovement in the Euro Area: Love at Second Sight?, Michal Andrle, Jan Bruha, and Serhat Solmaz investigate the co-movement between inflation and output in the euro area from 1995 up to the first quarter 2013. They find the relationship to be "rather strong at business cycle frequency, when a measure of trimmed mean inflation is considered and a sluggish response of inflation to demand is accounted for".

At business cycle frequency, they say, "the output and core inflation co-movement is high and stable", and "inflation lags the cycle in output with roughly half of its variance". The strong relationship of output and inflation, they say, "hints at the importance of demand shocks for the euro area business cycle".

The authors say that the relationship between output and inflation that they find is consistent with the response of New Keynesian models to demand shocks, not technology shocks.