One of the most contentious issues in monetary policy is whether inflation rates are primarily driven by national or international factors (e.g. Yellen 2006, Bernanke 2007, Caruana 2012, Carney 2015, Fischer 2015, Draghi 2016, Poloz 2016).
While it is well established that inflation co-moves closely across countries (e.g. Mumtaz and Surico 2009, 2012, Ciccarelli and Mojon 2010), the reasons for this positive co-movement are not well understood. The international correlation of inflation could, on the one hand, be due to common structural trends and similar policies, or on the other hand to cross-country propagation of inflationary shocks via real and financial channels.
Different answers to the question of why inflation co-moves across countries have far-reaching implications for the conduct of national monetary policy and the scope for international monetary cooperation. Understanding the mechanisms behind international inflation synchronisation is important for inflation forecasting, optimal monetary policy, international policy coordination, and currency unions, among other areas. One example is the increasing role of the global slack for domestic inflation in the Philips curve (e.g. Borio and Filardo 2007, and in particular Auer et al. 2017a in the context of global value chains), which signals changed trade-offs for the conduct of national monetary policy.
In recent research (Auer et al. 2017b), we show that the cross-border propagation of cost shocks through input-output linkages contributes substantially to synchronising producer price inflation (PPI) across countries. In the first step of the analysis, we recover the cost shocks that are consistent with observed price dynamics, given the global network of input-output trade. In the second step, we compare the extent of global synchronisation in observed PPI and the recovered cost shock series and attribute the difference to the impact of linkages.
Global value chains lead to sizeable spillovers
We assemble a unique dataset that combines monthly disaggregated producer price indices with data on sectoral domestic and international input trade from the World Input-Output Database (WIOD). The WIOD provides information on cross-border input shares by country-sector pairs. Our data cover 30 countries and 17 sectors over the period 1995-2011 (see Timmer et al. 2015).
We start our analysis by showing how strong cross-country spillovers are. As a preliminary investigation, we simulate hypothetical inflation shocks and use the WIOD to compute how they propagate across countries. The strength of international input-output linkages is such that global inflation shocks transmit significantly into countries. On average, a shock that raises inflation by 1% in other countries in the world other than the country under observation raises domestic PPI by 0.19% (see Figure 1). There is substantial cross-country heterogeneity in the extent to which international price changes affect domestic inflation. At the top end, there are three countries with elasticities with respect to global inflation of over 0.3 – Hungary, Belgium, and the Czech Republic. Russia, Australia, Japan, and the US appear the least susceptible to global inflation shocks, with elasticities in the range of 0.06-0.10.
Figure 1 Country-specific impact of a 1% inflationary shock in every other country
Global value chains also explain inflation synchronisation
Our main analysis examines the extent to which international input-output linkages affect the co-movement of actual PPI inflation. It recovers country-specific cost shocks, using the network of cross-country and cross-sector input-output linkages. It then compares the extent of cross-country synchronisation in the actual monthly disaggregated producer price indices with the extent of synchronisation in the underlying cost shocks. The incremental increase in synchronisation of actual monthly disaggregated producer price indices compared to the cost shocks is then attributed to the cross-border propagation of inflationary shocks through input linkages.
The main finding is that international input-output linkages matter a great deal for inflation synchronisation. The extent of synchronisation of observed PPI is roughly double the level of synchronisation in the underlying cost shocks. A conservative estimate is that for the median country, the global component accounts for 51% of the variance of PPI, whereas the global component accounts for only 28% of the variance of the cost shocks.
The mechanisms underlying propagation
We next examine the channels through which global input-output linkages synchronise inflation. We investigate the role of exchange rate movements, pricing-to-market, and the heterogeneity in cross-border input linkages in generating inflation co-movement. This presents four key findings.
- First, exchange rate movements do not play a role in synchronising inflation across countries. In a counterfactual that ignores exchange rate movements when recovering the underlying shocks, the common component in the recovered cost shocks is approximately the same as in the baseline.
- Second, the degree of pricing-to-market does not play a large role in inflation synchronisation. This is because the impact of limited cost pass-through and greater price complementarities roughly balance. We implement a scenario that features price complementarities following Burstein and Gopinath (2014), such that each seller's pricing rule is a function of both its cost shock (with elasticity β), and the prices of all other sellers supplying that market (with elasticity 1-β). Our main result that input linkages contribute substantially to synchronisation remains unchanged when allowing for various degrees of pricing-to-market.
- Third, heterogeneity in the strength of input-output linkages across sectors and countries contributes modestly to international co-movement. We compute two different counterfactual PPIs that would arise under the baseline recovered cost shocks, but in a world in which there is no sectoral or country heterogeneity in input linkages, and examine the co-movement of the resulting counterfactual PPIs. The results suggest that heterogeneity in input linkages - over and above the average level of linkages - does contribute to global inflation synchronisation.
- Finally, PPI synchronisation across countries is driven by common sectoral shocks, and input-output linkages amplify co-movement primarily by propagating sectoral shocks. To show this result, we implement a dynamic factor model that decomposes the underlying sector-level PPI fluctuations into the global, sectoral, and country factors following the methodology developed in Jackson et al. (2015). The first main result is that global PPI co-movement is not accounted for by global shocks (i.e. shocks to all sectors and all countries) but rather by sectoral ones (i.e. shocks to a specific sector in all countries conditional on the global shock). The second result is that international input-output linkages increase global co-movement by increasing the share of the variance explained by sectoral shocks. These findings are consistent with the view that global co-movement arises due to idiosyncratic developments in individual sectors such as the energy or transportation equipment industries, which spill over both across borders and sectors via input-output linkages, thereby synchronising national PPIs.
In this column, we have first argued that global input-output linkages can explain a sizeable share of the international co-movement of inflation, and second, we have pinpointed the mechanisms by which they do so.
We focused on the case of producer price inflation, as producer prices can naturally be linked to the sectoral network structure of global input-output trade. In related work at the country level, Auer et al. (2017a) find that global value chains are also closely associated with the way in which CPI inflation is globalising – both over time and across countries, the growth of global value chains can be closely related to the extent to which foreign economic slack is increasingly driving domestic consumer price inflation.
These findings are significant as they document that cost propagation, rather than correlated shocks, are responsible for the bulk of inflation synchronisation. The policy relevance of this finding goes beyond potential usefulness in inflation forecasting, as the propagation channel we document has implications for optimal monetary policy. In particular, the extent to which foreign marginal costs affect domestic distortions has been shown to play a pivotal role in whether optimal monetary policy in an open economy targets only domestic prices and output gaps (Corsetti et al. 2010, Lombardo and Ravenna 2014). As international input linkages represent a direct link between foreign marginal costs and domestic production costs, their prevalence has a first-order effect on the extent to which optimal monetary policy is inward-looking.
Authors’ note: The views expressed in this column are those of the authors and do not necessarily reflect those of the Bank for International Settlements or the Swiss National Bank.
Auer, R, C Borio, and A Filardo (2017a), “The globalisation of inflation: the growing importance of global value chains”, CEPR Discussion Paper 11905, March.
Auer, R, A A Levchenko, and P Sauré (2017b), “International Inflation Spillovers through Input Linkages”, CEPR Discussion Paper 11906, March.
Bernanke, B (2007), “Globalization and Monetary Policy”, Speech at the Fourth Economic Summit, Stanford Institute for Economic Policy Research.
Borio, C E V, and A Filardo (2007), “Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation”, BIS Working Paper 227.
Burstein, A, and G Gopinath (2014), “International Prices and Exchange Rates”, Handbook of International Economics 4.
Carney, M (2015), “Remarks at the Economic Policy Symposium” hosted by the Federal Reserve Bank of Kansas City, Jackson Hole, 29 August.
Caruana, J (2012), “The role of central banks in macroeconomic and financial stability: the challenges in an uncertain and volatile world”, Speech at the CEMLA-SEACEN conference, Punta del Este, Uruguay, 16 November.
Ciccarelli, M, and B Mojon (2010), “Global Inflation”, Review of Economics and Statistics, Vol. 92 (3).
Corsetti, G, L Dedola, and S Leduc (2010), “Optimal Monetary Policy in Open Economies”, in B M Friedman and M Woodford (eds.), Handbook of Monetary Economics, Vol. 3.
Draghi, M (2016), “How central banks meet the challenge of low inflation”, Marjolin lecture, Frankfurt, 4 February.
Fischer, S (2015), “U.S. Inflation Developments”, Speech at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, 29 August.
Jackson, L E, M A Kose, C Otrok, and M T Owyang (2015), “Specification and Estimation of Bayesian Dynamic Factor Models: A Monte Carlo Analysis with an Application to Global House Price Comovement”, in E Hillebrand and S J Koopman (eds.), Advances in Econometrics, vol. 35, Emerald Insight.
Mumtaz, H, and P Surico (2012), “The Transmission of International Shocks: A Factor-Augmented VAR Approach”, Journal of Money, Credit and Banking 41(s1).
Mumtaz, H, and P Surico (2012), “Evolving International Inflation Dynamics: World And Country-Specific Factors”, Journal of the European Economic Association 10(4).
Lombardo, G, and F Ravenna (2014), “Openness and optimal monetary policy”, Journal of International Economics 93(1).
Poloz, S (2016), “Cross-border trade integration and monetary policy”, The Paul Storer Memorial Lecture, delivered at Western Washington University, Bellingham, WA.
Timmer, M P, E Dietzenbacher, B Los, R Stehrer, and G J de Vries (2015), “An Illustrated User Guide to the World Input-Output Database: the Case of Global Automotive Production”, Review of International Economics 23(3).
Yellen, J L (2006), Speech at the Euro and the Dollar in a Globalized Economy Conference, May 27, Federal Reserve Bank of San Francisco.