Variation in the cyclical sensitivity of Spanish inflation: an initial approximation

In the advanced economies as a whole, inflation has in recent years shown considerable downward stickiness. This is particularly striking in light of the intensity of the recession. Against this background, several recent papers have analysed the relationship between the dynamics of prices and activity, providing a set of potential explanations for the downward stickiness of inflation during this latest crisis [see, for example, IMF (2013) or Matheson and Stavrev (2013)]. It has been pointed out that the limited impact of the decline in activity on inflation might be indicative of moderate output gaps. The recently observed notable increases in unemployment rates would largely be structural in nature, so their influence on wage bargaining and price-setting would be less than if they were merely cyclical. Also highlighted is the fact that the low rates of inflation observed in recent years and their scant variability reflect the price-stability strategies pursued by numerous central banks, as is the case of the Eurosystem. In keeping with this hypothesis, the anchoring of inflation expectations around moderate levels would explain small fluctuations in price variations around reference values. Other explanations of the downward stickiness of inflation point to globalisation, attributing a greater response by prices to the degree of slack in the world economy, with less influence exerted by the national cyclical situation. Also, a lesser response to the cycle by business margins or, indeed, their countercyclical nature, would also contribute to explaining the stability of inflation in a recessionary context such as the present. Lastly, inflation rigidity might increase if companies optimise their prices less frequently when average inflation falls. As a phenomenon, the reduction in the cyclical sensitivity of inflation has not been observed in all countries. For instance, the behaviour of the Spanish economy in the recent period has differed from this pattern. Despite the upward momentum in prices linked to the fiscal consolidation process (see the right-hand side panel of Chart 1), inflation has declined to a greater extent than in other advanced economies (left-hand side panel of Chart 1). Specifically, the differential with the euro area in terms of the overall consumer price index has dipped from approximately 1 pp on average in the 1996-2007 period to close to 0.2 pp in the recessionary phase (2008-2012), a reduction which has been even sharper in terms of core inflation. Indeed, the cyclical sensitivity of Spanish inflation appears to have increased in recent years, which would be consistent with some reduction in nominal rigidities. In the current setting, marked by weak domestic demand and the need to achieve gains in competitiveness, this response is particularly beneficial since the ensuing moderation in prices is providing for momentum in net external demand and softening the decline in domestic demand. The aim of this article, which summarises the initial findings of a more extensive project that analyses price-setting policies, is to provide empirical evidence on the changes in the response by Spanish inflation to fluctuations in activity since the onset of the recession. Section 2 presents a description of the relationship between various measures of inflation and activity. Section 3 sets out the results of several econometric estimates. And in the final section, conclusions are drawn.