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

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 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 Martinez-Garcia and Wynne (2010) can be approximated by a finiteorder 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.