Non-linearities in the Phillips curve: Evidence from the euro area

Non-linearities in the inflation – output relationship at an aggregate or a sectoral level seems to be a particularly convincing explanation for the observed inflation dynamics in the post-pandemic period. Therefore, in this work, we tested the validity of cross-equation restrictions implied from an aggregate Phillips curve under linear and non-linear stochastic bivariate representations for core inflation and the output gap, using quarterly data from the euro area over the period 2000–2024. A novel feature of our approach was that we did not assume an expectations formation mechanism, but we restricted expectations to be consistent with the aggregate supply and a large information set that included the history of core inflation and the tightness of economic activity. The results provided strong support for the non-linearities argument in explaining the recent quick rise and the subsequent immaculate and rapid fall in inflation. An important policy implication is that the European Central Bank has rightfully not insisted on interest rate hikes, as the inflation episode appears to be mostly a supply side issue.