The impact of global economies on US inflation: A test of the Phillips curve

Abstract

Understanding the relationship between employment and inflation is of great interest to policymakers and market participants. This paper introduces a new global inflation measure based on the principal component analysis (PCA) of the inflation rates of major US trade partners. We find that US domestic inflation correlates strongly with global inflation in the short- and long term. Moreover, global inflation leads the US inflation and accounts for 80% of the price discovery process. Additionally, we show that the Phillips curve equation improves in-sample and out-of-sample forecasting of US inflation rates by incorporating our spill-over-based global inflation (SGI) measure. Also, the utilization of the SGI in the Phillips equation increases the responsivity of the inflation rate data to the unemployment gap by 37%. In summary, the present results support the hypothesis that global inflation is a crucial determinant of domestic (US) inflation. The paper's main findings draw vital policy implications that emphasize the need for stronger cooperation among central banks to cope with the spill-over effect of global inflations on domestic economies.