Inflation and Inflation Uncertainty in the Euro Area

The results of full-sample Granger-causality tests using the specification including a
shift dummy for the break detected in 2000m1 are consistent with the earlier ones.
However, when carried out separately over the two sub-samples 1990m1-1998m6 and
2001m3-200m2, such tests provide evidence of a reversal in causality, implying that
the Cukierman-Meltzer link has been replaced by the Friedman-Ball one in the second
subsample (see Table 5), and that the ECB can effectively reduce inflation uncertainty
by bringing down the inflation rate.

Table 5. Test for Granger-causality, p - values

5. Conclusions

This paper estimates a time-varying AR-GARCH model of inflation for the euro area,
and investigates its linkages with the resulting measures of inflation uncertainty in a
bivariate VAR framework, also modelling the possible structural break resulting from
the creation of EMU at the beginning of 1999. Obtaining accurate measures of
inflation uncertainty is crucial for monetary authorities, since higher uncertainty
requires more active policies, as pointed out by Soderstrom (2002). Our main findings
are as follows. Steady-state inflation and inflation uncertainty have both declined
steadily since the inception of EMU, whilst short-run uncertainty has increased, but
mainly owing to exogenous shocks. A sequential dummy procedure provides further
evidence of a break coinciding with the introduction of the euro and leading to lower
long-run uncertainty.

Interestingly, our analysis suggests that a tough anti-inflation stance successfully
reduces long-run uncertainty in the case of the Eurozone, whilst the opposite holds for
the US, where tighter policies adopted by the Fed seem to lead to lower predictability
(see Benati and Surico, 2008 and Cogley et al., 2009). This might reflect differences
in the mandate of the two central banks. Whilst the ECB is responsible for price
stability only, the Fed pursues both price stability and full employment, two goals
which at times can be in conflict. Moreover, whilst the ECB adopts a clear
quantitative definition of price stability, no such definition is available in the case of
the Fed.

It also appears that the direction of causality has been reversed, and that in the euro
period the Friedman-Ball link is empirically supported, implying that the ECB can
achieve lower inflation uncertainty by lowering the inflation rate. This is consistent
with Fountas et al. (2004) and Conrad and Karanasos (2005) and with the idea that,
given the ECB’s mandate and its record so far, any long-lasting deviations from price
stability in the Eurozone would surprise market participants and lead to higher
inflation uncertainty.

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