By Sora Chon, Fellow at KDI
※ This article is part of KDI Journal of Economic Policy, May 2020
Many theoretical inflation models, represented by the Phillips curve, predict that there exists a meaningful relationship between economy activity and inflation. However, recent studies provide empirical evidence that the link between the real economy and inflation has weakened or disappeared since early 2000s. The macroeconomic phenomenon which casts doubt on the theoretical prediction is referred to as the ‘missing disinflation puzzle’. Regarding new empirical findings, special attention is paid to the role of a global inflation factor that triggers simultaneous movements in many countries’ inflation rates. Many studies in the literature argue that the missing disinflation puzzle is partially attributed to the changed importance of the global inflation factor in recent decades (e.g., Ciccarelli and Mojon, 2010; Mumtaz and Surico, 2012; Mikolajun and Lodge, 2016).
Global inflation synchronization is also linked to the low inflation rates commonly observed in major developed countries approximately since 2012. For instance, inflation rates were close to 0% in European countries and in the United States during this period. Sluggish inflation raises concern about deflation along with prolonged economic downturns, motivating central banks to implement non-traditional monetary policies such as massive quantitative easing to bring inflation rates up to their target rates. This new policy instrument has led to a sharp rise in asset prices in the capital markets via the excessive liquidity supply and low interest rates. As such, global inflation synchronization has a deep connection not only to inflation but also to various parts of the economy. Currently, many studies, such as that by Constâncio (2014), are underway. Moreover, central banks and international organizations are closely watching this unprecedented phenomenon. Related to this Hall (2011) and Christiano et al. (2015) study how low inflation and a slow economic recovery are connected to the causes of the Great Recession.
The aim of this study is to suggest policy implications for the Korean economy associated with global inflation synchronization. Considering that the Korean economy heavily relies on international trade, it would be important to understand how the global phenomenon affects inflation in Korea. The Korea inflation rate has continued to fall below the Bank of Korea's inflation target rate in recent years. This could be a natural consequence of Korea being more affected by the low level of the global inflation factor rather than by certain domestic factors.
This study is related to previous studies in the literature. Ciccarelli and Mojon (2010) empirically demonstrate that a single global inflation factor can suitably explain the inflation rates of many countries and allows for improved inflation forecasting. Borio and Filardo (2007) show that structural changes in the global aggregate demand explain global inflation dynamics. Melitz and Ottaviano (2008) point to trade liberalization as a source of global inflation synchronization. Cecchetti et al. (2007), Rogoff (2003), Mumtaz and Surico (2012), and Conti et al. (2017) emphasize the role of traditional monetary policies on inflation synchronization and low inflation. Mumtaz and Surico (2012) show that the low inflation has been commonly observed in many developed countries since 1980s and argue that such a change in the inflation dynamics is directly linked to global currency depreciation. Lastly, Mikolajun and Lodge (2016) provide evidence that a global inflation factor explains the inflation rates of individual countries well, but the influence of the global factor is already absorbed in domestic macro-variables. They conclude that there is no need to consider the global factor separately when explaining the inflation rates of individual countries.
Unlike the aforementioned papers, this study considers the possibility that there exist several global inflation factors rather than just one. To extract potential factors, a principal component analysis (PCA) is applied to panel data of inflation rates and the estimated principal components are then employed to explain and predict Korean inflation rates. A particularly striking result is that the first principal component is closely related to the OECD weighted average inflation rate, while the second and third principal components are closely related to China’s inflation rate.
One of the difficulties in an empirical analysis of Korean inflation is that the sample size of Korean macroeconomic variables is not yet sufficiently accumulated for reliable statistical inference, as the Bank of Korea changed its monetary policy base to inflation targeting in 1998. Due to the lack of data information, it is practically difficult to carry out a precise quantitative analysis in empirical models in which both global inflation factors and domestic macro-variables are included. This study resolves this practical issue by employing the LASSO (Least Absolute Shrinkage and Selection Operator) methodology of Tibshirani (1996). LASSO is a widely used technique in the machine learning literature in cases involving a limited amount of data compared to the number of coefficients.
The main empirical findings of this study are as follows. The global inflation principal components play important roles in explaining and predicting Korea's inflation rate in the short-term. However, in the mid-term, the performance of the global inflation principal components in terms of in-sample fitting and out-of-sample forecasting substantially diminishes. On the other hand, Korean macro-variables provide better explanatory and prediction power in the mid-term than the global inflation principal components. In light of this point, the recent economic downturn in the global economy and the resulting low global inflation may have only a limited effect on the inflation rate in Korea in the mid-term. In addition, the Bank of Korea, whose policy goal is to keep domestic prices stable, appears to be more apt to adjust its monetary policy in accordance with Korean economic situations. However, this does not necessarily mean that the Bank of Korea should ignore global inflation factors. Rather, it means that because global factors change Korean macro-variables in the mid-term, it is better carefully to monitor the macro-variables which already reflect global economic conditions when enacting its monetary policies.
The composition of this paper is as follows. In Section 2, we examine the inflation synchronization phenomenon using panel data for inflation rates. Also, we estimate the global inflation factors via PCA and shows how inflation in each individual country is explained by common factors. In Section 3, international and domestic macro-variables relevant to the inflation rate of Korea are extracted from LASSO. Section 4 discusses policy implications based on the results of Sections 2 and 3. Section 5 provides concluding remarks.
※ This paper is based on Sora Chon, 2018, International Inflation Synchronization and the Implications
, Policy Study 2018-07, KDI (in Korean).