The global dimension of inflation –evidence from factor-augmented Phillips curves

We examine the global dimension of inflation in 24 OECD countries between 1980 and 2007in a traditional Phillips curve framework. We decompose output gaps and changes in unitlabor costs into common (or global) and idiosyncratic components using a factor analysis andintroduce these components separately in the regression. Unlike previous studies, we allowglobal forces to affect inflation through (the common part of) domestic demand and supplyconditions. Our most important result is that the common component of changes in unit laborcosts notably affects inflation. We also find evidence that movements in import price inflationhave small effects on CPI inflation while the impact of movements in the common componentof the output gap is unclear. A counterfactual experiment illustrates that the commoncomponent of unit labor cost changes and non-commodity import price inflation have helddown overall inflation in many countries in recent years. Our results imply that monetarypolicy makers need to carefully monitor global forces when assessing and predicting inflation.In analogy to the Phillips curves, we estimate monetary policy rules with common andidiosyncratic components of inflation and the output gap included separately. Central bankshave indeed reacted to the global components.[...]