Hong Kong Inflation Dynamics: Trend and Cycle Relationships with the U.S. and China

This paper analyzes trend and cycle movements of Hong Kong inflation. The empirical model is an unobserved components model that is consistent with the New Keynesian Phillips curve and is estimated using Hong Kong, U.S., and China inflation and output data. The model decomposes Hong Kong inflation into a stochastic trend and a stationary cycle component that is driven by domestic as well as U.S. and China output gaps. The output gaps are treated as latent variables, thus a byproduct of estimating the empirical model are measures of the output gaps for Hong Kong that are consistent with the New Keynesian Phillips Curve. Empirical results suggest minor evidence that Hong Kong and U.S. inflation rates are related in the long-run, as permanent price shocks from the U.S. have minimal effects on Hong Kong trend inflation movements. Over the short-run horizon, Hong Kong price movements are heavily driven by both the domestic output gap as well as external forces. The U.S. and China output gap has opposite effects on the cycle component of Hong Kong inflation, with the coefficients on the China output gap twice as large as those on the U.S. are.