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

We propose a novel metric to evaluate price developments within the euro area (EA), which involves the decomposition of the overall variability of cross country inflation rates into common and idiosyncratic labor cost and markup components. The analysis yields several interesting results. First, over the period 1978-2015, inflation variability in the EA reflects most of all idiosyncratic (country-specific) developments in unit labor costs (ULC). This sharply contrasts with what we find for the US states, where price dynamics to a much greater extent reflects common developments in costs and profits, consistently with the role played by the greater mobility of capital and labor. Second, when we apply our approach to data for two subgroups of countries, namely Core and Non-core countries, we find that they both display higher intra-group homogeneity, in that the role of the subgroup-specific common components in explaining inflation variability increases, while idiosyncratic developments in ULC become correspondingly less relevant. Third, over the more recent period (1999-2015) in the Core countries the idiosyncratic component due to price markups has become the dominant driver of the variability of inflation, 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 developments of ULC are reflected into trade balance adjustments that are costly from the point of view of the smooth functioning of the currency area.