Global or domestic? Which shocks drive inflation in the small open economies?

In the paper we investigate to what extent the inflation in small open economies is driven by global demand and supply shocks. The experience of the last decades reveals the growing role of the global factors in shaping inflation in many economies. As indicated by Borio and Filardo [2007] and Ciccareli and Mojon [2008] this phenomenon is usually explained by growing impact of globalization related to increasing turnovers in international trade combined by falling unit labour costs in China and other emerging economies. While the most of research related to the impact of globalization on inflation works with macro data we conduct the analysis using disaggregated price indices. In the research we focus on Central and Eastern European economies tightly integrated via trade and financial channel with the euro area and due to their involvement in global value chains strongly affected by the globalization process.We proceed in two steps. In the first step we use SVAR methodology with sign restrictions as proposed by Canova and De Nicolo [2002] and Frey and Pagan [2011] and from the set of global variables we extract three shocks, which may contribute the most to the overall variability of inflation: global demand shock, commodity specific shock and non-commodity supply shock associated, to some extent, with the globalization process. In the second step we regress the dissagregated price indices for selected CEE economies (Poland, Czech Republic and Hungary) on the global shocks extracted in the previous step simultaneously controlling for the domestic output gap and exchange rate. This approach allows us to identify these groups of goods of services which prices react the most to the global shocks in particular to non-commodity supply shock.The general outcome stemming from our analysis indicate that the role of the global shocks in shaping inflation in CEE economies relies on their size and openness. The global supply and demand shocks are transmitted to the domestic inflation to greater extent for smaller and more open economies. However there are several similarities across the CEE economies. The supply shocks in all countries affect prices of semi durables, mostly clothing and footwear, but also communication or transport. Since we assign supply shocks to the globalization and technological progress it is not a surprise. The dynamics of clothing’s prices exhibit downward trend which can be attributed to the movement of the production to the countries with lower production costs. Similar explanation relates to the prices of transport equipment. The relationship between global supply shocks and prices of communication may be also explained to some extent by globalization process reflected in growing productiveness and increasing competitiveness on this market. The influence of the global demand shocks on the inflation in the analyzed countries is not the crucial one. For Poland, which is the biggest country, with the largest domestic market, the most of the analyzed price indices react to the domestic output gap rather than global demand shocks. For the two other countries – Hungary and Czech Republic, which are smaller and more open economies – both: domestic output gaps and global demand shocks are less important for the domestic inflation. According to our intuition prices of energy and transport (which are strongly influenced by oil prices) in all analyzed countries are affected by the commodity shocks.