Global factors and trend inflation

Summary

Focus

Many studies have shown that domestic inflation in different countries tends to behave similarly. One possible explanation for this observation is that domestic inflation dynamics are in part determined by global factors. This implies that central banks need to account for global factors when explaining and predicting inflation. Their importance however depends on whether they have long lasting effects on domestic inflation rates.

Contribution

Using a large macroeconomic dataset, we propose a methodology to decompose inflation into its permanent (trend) and transitory (gap) components. We then quantify the role of domestic and global factors in determining each of these components. We first apply the model to a sample of economies with long-standing inflation targeting regimes. We then extend our analysis to a sample of ten Asian economies to draw comparisons.

Findings

In our first sample, we find that global factors have a sizeable influence on inflation behaviour.   However, this is mainly temporary and appears to reflect movements in commodity prices. The effect of global factors on trend inflation is small. In our second sample, a set of countries with more diverse monetary policy regimes, we find global factors have a much larger role. A possible explanation is that inflation targeting may have reduced the influence of global factors on trend inflation.

Abstract

We develop a model to empirically study the influence of global factors in driving trend inflation and the inflation gap.We apply our model to five established inflation targeters and a group of heterogeneous Asian economies. Our results suggest that while global factors can have a sizeable influence on the inflation gap, they play only a marginal role in driving trend inflation. Much of the influence of global factors in the inflation gap may be reflecting commodity price shocks. We also find global factors have a greater influence on inflation, and especially trend inflation, for the group of Asian economies relative to the established inflation targeters. A possible interpretation is that inflation targeting may have reduced the influence of global factors on inflation, and especially so on trend inflation.

JEL classification: C32, E31, F41

Keywords: trend inflation, foreign shocks, Beveridge-Nelson decomposition