Forecasting Local Inflation with Global Inflation: When Economic Theory Meets the Facts

34 Pages Posted: 5 Apr 2015

See all articles by Roberto Duncan

Roberto Duncan

Ohio University - Department of Economics

Enrique Martínez-García

Federal Reserve Bank of Dallas - Research Department

Date Written: March 30, 2015

Abstract

This paper provides both theoretical insight as well as empirical evidence in support of the view that inflation is largely a global phenomenon. First, we show that inflation across countries incorporates a significant common factor captured by global inflation. Second, we show that in theory a role for global inflation in local inflation dynamics emerges over the business cycle even without common shocks, and under flexible exchange rates and complete international asset markets. Third, 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 (e.g., Ciccarelli and Mojon (2010)). Fourth, we argue that the workhorse New Open Economy Macro (NOEM) model of Martínez-García and Wynne (2010) can be approximated by a finite-order VAR and estimated using Bayesian techniques to forecast domestic inflation incorporating all relevant linkages with the rest of the world. This NOEM-BVAR provides a tractable model of inflation determination that can be tested empirically in forecasting. Finally, we use pseudo-out-of-sample forecasts to assess the NOEM-BVAR at different horizons (1 to 8 quarters ahead) across 17 OECD countries using quarterly data over the period 1980Q1-2014Q4. In general, we find that the NOEM-BVAR model produces a lower root mean squared prediction error (RMSPE) than its competitors --- which include most conventional forecasting models based on domestic factors and also the recent models based on global inflation. In a number of cases, the gains in smaller RMSPEs are statistically significant. The NOEM-BVAR model is also accurate in predicting the direction of change for inflation, and often better than its competitors along this dimension too.

Keywords: Global Inflation, Global Slack Hypothesis, New Open Economy Macroeconomics, Open-Economy Phillips Curves, Inflation Forecasting

JEL Classification: E31, F41, F42, F47

Suggested Citation

Duncan, Roberto and Martinez-Garcia, Enrique, Forecasting Local Inflation with Global Inflation: When Economic Theory Meets the Facts (March 30, 2015). Available at SSRN: https://ssrn.com/abstract=2589712 or http://dx.doi.org/10.2139/ssrn.2589712

Roberto Duncan (Contact Author)

Ohio University - Department of Economics ( email )

Athens, OH 45701-2979
United States

HOME PAGE: http://www.ohio.edu/people/duncanr1/

Enrique Martinez-Garcia

Federal Reserve Bank of Dallas - Research Department ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5262 (Phone)

HOME PAGE: http://sites.google.com/view/emgeconomics

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