Relative Price Dynamics in the Euro Area: Where Do We Stand?

Abstract

We propose a new metric to evaluate price developments within the euro area (EA), which involves decomposing the overall variability of inflation rates across countries into common and idiosyncratic labour cost and markup components. The analysis yields several interesting results. First, over the period 1978-2015, inflation variability in the EA reflects above all idiosyncratic (country-specific) developments in unit labour costs (ULC). This contrasts sharply with what we find for the United States (US), where price dynamics at the state level reflect common developments in costs and profits to a much greater extent, consistent with the role played by the greater mobility of capital and labour. Second, when we apply our approach to the data for two subgroups of countries, namely Core and Non-Core countries, we find that they both display higher intra-group homogeneity, given that the role of the subgroup-specific common components in explaining inflation variability becomes more important, while idiosyncratic developments in ULC become correspondingly less significant. Third, in more recent years (1999-2015) the idiosyncratic component due to price markups has become the dominant driver of the variability of inflation in the Core countries, a pattern similar to the one we detect for the US. Our analysis also sheds light on the adjustment mechanisms to asymmetric, or country specific, shocks. Using a panel VAR approach we find that price changes driven by diverging changes in ULC are reflected into trade balance adjustments that are costly from the point of view of the smooth functioning of the currency area.