Inflation modelling in the euro area

Introduction Controlling inflation, at least in the long run, is widely regarded as the primary, and sometimes the only, goal of monetary policy. To this aim, in many countries central banks have explicitly adopted inflation-targeting strategies, setting precise quantitative targets for the monetary authorities' actions. Though not an inflation targeter, the European Central Bank (ECB) adopted a monetary policy strategy aimed at maintaining an annual inflation rate below 2% over a medium-term horizon (ECB 1999). This strategy is based on an announced reference value for M3 money growth and on the outlook of price developments in the euro area. The analysis of the behaviour of monetary aggregates and their components relies on a number of tools recently summarised in ECB (2001). The aim of this chapter is to provide an empirical investigation of the inter-relationships among money, prices, interest rates and output in the euro area with a particular focus on the behaviour of the inflation rate over a long-run horizon. In fact, one of the main open issues in inflation analysis stems from the fact that short-run fluctuations of the observed inflation rate may be due to only temporary disturbances to which monetary policy should not respond. How to construct a reliable empirical measure of the underlying, long-run trend of inflation – ‘core’ inflation – has therefore become a crucial issue in monetary policy design. Core inflation series have been constructed following different methodologies (see Wynne 1999 for a thorough overview and assessment of different measures).