Detecting inflation regime shifts in the euro area: the role of money growth

Summary

This study employs an adjusted money growth indicator to identify inflation regime shifts in the euro area. A two-regime LSTAR model reveals that when adjusted M3 growth surpasses 5%, a high[1]inflation regime typically follows after about ten months. This regime is marked by persistent dynamics and a higher average inflation rate. The inflation surge from early 2021 to late 2022 aligns with periods of elevated adjusted money growth, underscoring the value of such indicators as complementary tools for tracking and anticipating inflation regime changes.

Highlights

Money signals regime shifts
Adjusted M3 growth above 5% triggers a transition to a high-inflation regime with an approximate ten-month lead. This 5% threshold was empirically estimated and provides policymakers with an early warning of potential inflation upturns.

High inflation shows persistence
Once in the high-inflation regime, inflation exhibits strong autoregressive dynamics, suggesting that elevated inflation persists longer.

Model captures post-pandemic spike
The smooth transition model successfully identifies the 2021– 2022 inflation surge, with regime probability peaking in January 2022 ahead of the 11.6% inflation peak in October 2022, validating the framework's real-world applicability.