European Central Bank working paper finds Phillips curve steepens in inflationary booms while monetary transmission weakens in inflationary slack

The European Central Bank published Working Paper No 3175 examining how the inflation–output relationship and monetary policy transmission change across business cycle phases. Using four regimes defined by whether inflation is above or below the Federal Reserve’s 2% target and whether output is above or below potential, the paper finds clear asymmetries in the Phillips curve, the dynamic IS (DIS) curve and the size and effectiveness of monetary policy shocks. Based on a Bayesian three-equation threshold vector autoregression estimated on monthly US data from January 1962 to December 2019, the Taylor principle holds across all regimes, with the policy response to inflation broadly similar across states. By contrast, the systematic response to the output gap weakens when inflation is below target but output is above potential, and policy is described as more data dependent in inflationary slack. The Phillips curve is steeper in an inflationary boom, while the sensitivity of the output gap to interest rate changes flattens when inflation is above target and output is below potential, a regime that accounts for 44% of the sample. Monetary policy shocks are materially larger when inflation exceeds target, reported as roughly twice as large in inflationary booms and three times as large in inflationary slack compared with disinflationary periods, and impulse responses show markedly smaller real and inflation effects of tightening in inflationary slack than in booms or disinflationary slack.