Inflation heterogeneity and diffusion dynamics in the euro area: A new normal?

This article examines inflation dynamics and cross-country diffusion patterns in the euro area. We explore the episode of high inflation, including structural changes in monetary policy by the European Central Bank. We employ a simulation methodology and utilizes monthly data from 1999 to 2024. Our research unravels six outcomes: (i) We exhibit distinct inflation clusters across the euro area. (ii) We find a heavy-tailed distribution of cumulative inflation gaps in the high inflation cluster. (iii) There exist a staggering 75 percent probability of overshooting the 2% target in the high inflation cluster. (iv) Inflation trajectories are not explained by a singular economic theory. We investigate a neural stochastic differential equation model. (v) The structural changes in monetary policy impairs the credibility of central banks. (vi) The heterogeneity in inflation dynamics and the structural changes constitute a new risk. Our research provides insights for policymakers within a heterogeneous euro area.