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Does global liquidity help to forecast U.S. inflation?

Article Excerpt
ACCURATE INFLATION FORECASTS are essential for successful monetary policymaking. Effective predictors are essential for producing accurate forecasts. In the recent past, characterized by low and stable inflation, researchers in academia and policy institutions have had difficulty to find a reliable predictor for inflation. As Stock and Watson (2007) emphasize, inflation has become so hard to forecast that it is difficult to improve upon the projections of a naive random walk.

A long-standing literature in macroeconomics has documented the long-run relationship between money growth and inflation (see, e.g., Lucas 1980, Friedman and Schwartz 1982, McCandless and Weber 1995, Benati 2007). It does not come as surprise, then, that central banks monitor monetary aggregates in an effort to predict movements in inflation. The European Central Bank goes as far as regarding the stabilization of the growth of a broad monetary aggregate as the first pillar of its monetary policy strategy.

We are grateful to the editor, Masao Ogaki, two anonymous referees, Luca Benati, and Michele Lenza for very useful comments and suggestions. The views expressed in this paper are those of the authors, and do not necessarily reflect those of the Central Bank and Financial Services Authority of Ireland or the Bank of England.

The information content of monetary indicators for inflation, however, has been recently called into question as a few studies, including Galf et al. (2004) and Gerlach and Svensson (2003), argue that domestic money growth has little predictive power for domestic inflation.

A growing empirical literature exemplified by Rogoff (2003) has shown that national inflation rates in several industrialized economies share a significant international common component. To the extent that money growth and inflation are highly correlated in the long run, significant international comovements in inflation may reflect significant international comovements in liquidity, which can then be used to forecast domestic inflation.

In this work, we investigate whether global liquidity has marginal predictive power for U.S. inflation. We find that global liquidity, measured as either the mean or the first dynamic principal component of the growth rates of broad money across the G7 economies, produces inflation forecasts that are significantly more accurate than the forecasts based on traditional models such as an autoregressive specification, a Phillips curve relationship, and a model based on U.S. money growth. The predictive advantage is particularly pronounced at the 3-year horizon. Results are robust to alternative measures of inflation.

The forecasting models and the measure of global liquidity are presented in Section 1. Section 2 reports the main results. Section 3 provides a robustness analysis and a discussion of some alternative forecasting equations proposed in recent contributions.

1. FORECASTING MODELS: OLD AND NEW

There are several channels through which global liquidity may have an impact on future domestic inflation. Over the last 20 years, inflation dynamics have become more synchronized: different countries have shared similar experiences with inflation becoming low and stable by the beginning of the 1990s.

Rogoff (2003) argues that improved monetary policies across the world has been one of the most significant driver of the great moderation. Along similar lines, Barsky and Kilian (2001) offer a monetary explanation of the great stagflation showing that a measure of world liquidity was highly correlated with U.S. monetary policy and inflation during the 1970s.

Another channel of transmission from global liquidity to domestic inflation operates through the terms of trade. If the exchange rate does not fully outweigh a rise in the import prices of intermediate and final goods, then domestic firms will face higher costs and consumers will demand higher wages as result of the deterioration of their purchasing power. By the same token, an inflow of capital from abroad that is not followed by a sufficient appreciation of the exchange rate can influence...

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