Have the driving forces of inflation changed in advanced and emerging market economies?

Summary

Focus

Inflation has remained remarkably stable in many economies since the Great Financial Crisis (GFC). The fact that inflation did not fall as much as might have been expected given the high degree of economic slack during the crisis or rise much in the recovery afterwards has raised questions about what contributed to the recent stability of inflation and whether the slope of the Phillips curve has flattened. This paper empirically investigates possible structural changes in the driving forces of inflation and their quantitative effects before, during and after the GFC for a number of advanced and emerging market economies.

Contribution

We construct a balanced panel data set for inflation and its potential drivers in 47 advanced and emerging market economies. Key variables include expected future inflation measured using professional forecasts and a foreign output gap measured using economy-specific trade weights. These variables allow us to estimate an open economy hybrid Phillips curve model for inflation and we formally test for possible structural breaks in the model parameters. We also track what the behaviour of variables in the model would predict for the level and volatility of inflation over time.

Findings

We find relatively little significant change in the driving forces of inflation or their quantitative effects for most of the 47 economies over the sample period from 1996 to 2018. However, a notable change has been an increase in the average weight on expected future inflation for both advanced and emerging market economies. We find very heterogeneous but significant effects for inflation expectations, domestic and foreign output gaps, exchange rate pass-through, and oil prices, with generally higher sensitivities to external driving forces for emerging market economies. Consistent with the open economy hybrid Phillips curve model of inflation, the behaviour of the various inflation drivers, especially better anchored inflation expectations, can explain patterns of changes in the level and volatility of inflation across different economies.

Abstract

We construct a balanced panel dataset for 47 advanced and emerging market economies over a sample period from 1996 to 2018 to empirically investigate possible changes in the driving forces of inflation. Using an open economy hybrid Phillips curve model of inflation and formally testing for structural breaks, we find relatively little significant change in the underlying driving forces or their quantitative effects for most economies, even after the Great Financial Crisis. However, one notable change has been an increase in the average weight on expected future inflation, measured using professional forecasts, for both advanced and emerging market economies. We find very heterogeneous but significant effects of inflation expectations, domestic and foreign output gaps, exchange rate passthrough, and oil prices, with generally higher sensitivities to external driving forces for emerging market economies. Consistent with the model, the behavior of the various inflation drivers, especially what appear to be better anchored inflation expectations, can explain patterns of changes in the level and volatility of inflation across different economies.

JEL Classification: E31, F31, F41

Keywords: open economy Phillips curve, structural breaks, inflation expectations, exchange rate passthrough, inflation volatility