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Forecasting inflation under globalisation


Two recent papers contribute to forecasting inflation in a world of convergent policy regimes and integrated economies. The first emphasizes the distinct effects of shocks to aggregate demand, supply, and monetary policy. The second explains why country inflation usually corrects deviations from trends in the rest of the world. Predominantly inflation has become a global force.

Melolinna, Marko, “What has driven inflation dynamics in the Euro area, the United Kingdom and the United States”, ECB Working Paper, no 1802, June 2015

Duncan, Roberto and Enrique Martinez-Garcia,” Forecasting Local Inflation with Global Inflation: When Economic Theory Meets the Facts”, Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute, Working Paper No. 235 http://www.dallasfed.org/assets/documents/institute/wpapers/2015/0235.pdf

The below are excerpts from papers. Headings and cursive text have been added.

The economic “shocks” that drive inflation

“The current study examines the effects of different macroeconomic shocks [unexpected changes to the economic environment]…There are four types of shocks in the model; demand, supply, monetary policy and ‘residual’…All shocks are orthogonal to each other [linearly independent and hence separable]

  • In a traditional demand/supply framework, demand shocks can be thought of as shocks that move the demand curve to the right, causing an increase in both activity and prices.
  • Supply shocks (typically cost shocks, like oil supply disruptions), on the other hand, move the supply curve to the left, leading to an increase in prices but a decrease in activity…
  • Monetary policy shocks are also included, with the conventional restrictions that in the short term, a rate cut will lead to an increase in prices and in real activity (or at least not to a decrease in prices and activity).
  • The…“residual” shock captures all effects not captured by the other three shocks. This can be assumed to include mainly expectational shocks, like changes in monetary policy credibility, as well as shocks to inflation persistence.”


The empirical pattern of response to inflationary shocks

“[The paper] introduces a factor-augmented vector autoregression framework…The aim is to identify different kinds of orthogonal shocks driving inflation developments…The model used…monthly data10 from 1975M1 to 2012M12…The four variables in the model are monetary policy rate (for the euro area, the 3-month short term market rate), a [composite] real activity factor, a [composite] cost factor (price variables in y/y change terms) and an inflation factor (in y/y change terms).”

“The impulse response functions [of inflation with respect to a one-standard-deviation shock of each type]… for the euro area, the UK and the US are presented in [the chart below]”


“Headline inflation in the three economies has reacted in a relatively similar fashion to macroeconomic shocks over the last four decades, with demand shocks causing the most persistent effects on inflation in all three cases. In the US, supply shocks have had more of a negative medium-term effect on the US economy, and the more pronounced short-term responses to shocks point to a more flexible pricing mechanism than in the European economies.”

“The current study offers further evidence on the importance of differentiating between demand and supply shocks…[In particular] for the services subcomponent, demand and monetary policy shocks have tended to be larger and more persistent drivers of inflation than supply shocks. This is probably due to the import price/exchange rate channel being less important for non-tradable services than for tradable goods.”

“The fact that shocks have tended to cause a more muted, but also more persistent response in the euro area than in the other two economies is consistent with other studies finding labour and product market to be less flexible in the euro area.”

A theory of global inflation links

“We study the joint dynamics of local and global inflation in the context of the workhorse New Open Economy Macro model that constitutes the cornerstone of mainstream international macro… we provide a very tractable framework to interpret the global determinants of global inflation and how those same economic forces are incorporated into local inflation.”

“The basic structure of the…model is given by…three-equations

  • A Phillips curve…[based on] price stickiness…in the short-run, establishing a relationship between nominal (inflation) and real variables (slack)…Consumption goods are…imported as well as domestic varieties…[giving rise to ] the global slack hypothesis… In a world open to trade the relevant trade-off for monetary policy captured by the Phillips curve is between a country’s inflation and global (rather than local) slack…
  • An investment-savings (IS) curve… The consequences of price stickiness are reflected in the wedge between the real interest rate (the actual opportunity cost of consumption today versus consumption tomorrow) and the natural real rate of interest that captures its distortionary effects on aggregate demand…
  • An interest rate-based monetary policy [Taylor] rule… Monetary policy pursues the goal of domestic stabilization (even in a fully integrated world) and, hence, solely responds to changes in the local economic conditions as determined by each country’s inflation and output gap.”

“An important contribution of the model is that it explains…why global inflation can be successfully used to predict domestic inflation…If, for example, there is a positive productivity shock in the rest of the world, that shock increases the external potential output, thus also changing the relative output across countries, the terms of trade and ultimately inflation. The fact that foreign products become relatively cheaper as a result leads to a substitution effect away from domestic goods, so domestic inflation is affected through imported prices but also through…the pricing decisions of domestic producers.”

“Global inflation is an attractor for local inflation in the sense that differences across countries and, with respect to the mean, tend to disappear over the long-run…The path of both global and local inflation will depend on the structural features of the economy and it can give rise to an ‘error correction mechanism’ that brings local and global inflation in line even absent common shocks and with complete international asset markets and flexible exchange rates…Free  floating exchange rates and complete international asset markets, thought to cushion the impact of foreign economic conditions, do not, in fact, negate the existence of a relationship between domestic inflation and global factors that we find useful to forecast inflation across most of the countries in our sample.”

Empirical evidence of global inflation links

“We use end-of-quarter and seasonally-adjusted data for a sample of 17 OECD economies during the 1980Q1-2014Q4 period. We focus on quarter-on-quarter inflation rates as measured by the headline Consumer Price Index (CPI).”

“Inflation is largely a global phenomenon…We show that inflation across countries incorporates a significant common factor captured by global inflation… we identify a strong ‘error correction mechanism’ that brings local inflation rates back in line with global inflation which explains the relative success of inflation forecasting models based on global inflation.”

“We present empirical findings indicating that a parsimonious forecasting model of inflation that exploits the standard linkages that arise in the workhorse New Open Economy Macro (NOEM) model tends to outperform other more conventional forecasting models of inflation (even those based on global inflation alone).”

Consequences of global inflation links

“Inflation should be modelled as a global rather than a purely local phenomenon…Global inflation can help forecast, but it is not sufficient to exhaust all relevant information about the cross-country spillovers…The evidence presented in this paper highlights the importance of recognizing those international spillovers and incorporating them fully into our forecasting models.”

Central banks no longer can ignore how attaining their own domestic goals depends on the actions of central bankers and policy-makers in other parts of the world…The main risk of ignoring international developments is to misinterpret the effect of domestic economic conditions…In this regard, U.S. policymakers should not ignore developments in the rest of the world simply because of the traditionally low import and export shares of the U.S. economy providing a false sense of security. Even when some countries are less affected by global inflation than others, given their differences in terms of monetary policy or the strength of the trade linkages, very few can claim to be generally immune to global factors.”

Ralph Sueppel is managing director for research and trading strategies at Macrosynergy. He has worked in economics and finance since the early 1990s for investment banks, the European Central Bank, and leading hedge funds.


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