Relative Goods&Apos; Prices, Pure Inflation, and the Phillips Correlation

This paper uses a dynamic factor model for the quarterly changes in consumption goods' prices to separate them into three independent components: idiosyncratic relative-price changes, a low-dimensional index of aggregate relative-price changes, and an index of equiproportional changes in all inflation rates, that we label "pure" inflation. The paper estimates the model on U.S. data since 1959, and it presents a simple structural model that relates the three components of price changes to fundamental economic shocks. We use the estimates of the pure inflation and aggregate relative-price components to answer two questions. First, what share of the variability of inflation is associated with each component, and how are they related to conventional measures of monetary policy and relative-price shocks? We find that pure inflation accounts for 15-20% of the variability in inflation while our aggregate relative-price index accounts most of the rest. Conventional measures of relative prices are strongly but far from perfectly correlated with our relative-price index; pure inflation is only weakly correlated with money growth rates, but more strongly correlated with nominal interest rates. Second, what drives the Phillips correlation between inflation and measures of real activity? We find that the Phillips correlation essentially disappears once we control for goods' relative-price changes. This supports modern theories of inflation dynamics based on price rigidities and many consumption goods.

[1]  C. R. Rao,et al.  Linear Statistical Inference and its Applications , 1968 .

[2]  Serena Ng,et al.  Determining the Number of Primitive Shocks in Factor Models , 2007 .

[3]  M. Watson,et al.  Measuring changes in the value of the numeraire , 2007 .

[4]  M. Hallin,et al.  Determining the Number of Factors in the General Dynamic Factor Model , 2007 .

[5]  S. Ramlee,et al.  Is the Fisher Effect for Real?: Testing the Robustness of the Long Run Fisher Effect in the G7 Countries , 2022 .

[6]  M. Friedman,et al.  A Monetary History of the United States , 1963 .

[7]  R. Shumway,et al.  AN APPROACH TO TIME SERIES SMOOTHING AND FORECASTING USING THE EM ALGORITHM , 1982 .

[8]  Simon Potter,et al.  Real Time Underlying Inflation Gauges for Monetary Policymakers , 2009 .

[9]  Calyampudi R. Rao,et al.  Linear Statistical Inference and Its Applications. , 1975 .

[10]  Olivier J. Blanchard,et al.  Monopolistic Competition and the Effects of Aggregate Demand , 1987 .

[11]  Jean Boivin,et al.  Measuring the Effects of Monetary Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach , 2003 .

[12]  C. Radhakrishna Rao,et al.  Linear Statistical Inference and its Applications, Second Editon , 1973, Wiley Series in Probability and Statistics.

[13]  L. Robert.  Some International Evidence on Output-Inflation Tradeoffs. , 1973 .

[14]  J. Bai,et al.  Confidence Intervals for Diffusion Index Forecasts and Inference for Factor-Augmented Regressions , 2006 .

[15]  J. G. Hülsmann,et al.  A theory of interest , 2002 .

[16]  D. Rao,et al.  Index Numbers: A Stochastic Approach , 1994 .

[17]  J. Stock,et al.  Business Cycle Fluctuations in U.S. Macroeconomic Time Series , 1998 .

[18]  Danny Quah,et al.  A Dynamic Index Model for Large Cross Sections , 1993 .

[19]  David E. Weinstein,et al.  Product Creation and Destruction: Evidence and Price Implications , 2007 .

[20]  Giovanni Veronese,et al.  A Core Inflation Indicator for the Euro Area , 2005 .

[21]  R. Reis,et al.  The persistence of inflation in the United States , 2007 .

[22]  J. Bai,et al.  Determining the Number of Factors in Approximate Factor Models , 2000 .

[23]  Weili Lin,et al.  Signal and Noise , 2001 .

[24]  R. Engle,et al.  Alternative Algorithms for the Estimation of Dynamic Factor , 1983 .

[25]  Mark W. Watson,et al.  Recursive solution methods for dynamic linear rational expectations models , 1989 .

[26]  Michael Woodford,et al.  Interest and Prices , 2011 .

[27]  Stephen G. Cecchetti,et al.  The Consumer Price Index as a Measure of Inflation , 2005 .

[28]  F. Dias,et al.  Determining the number of factors in approximate factor models with global and group-specific factors , 2008 .

[29]  J. Bai,et al.  Inferential Theory for Factor Models of Large Dimensions , 2003 .

[30]  T. M. Humphrey.  The Persistence of Inflation , 1979 .

[31]  J. Stock,et al.  Forecasting Using Principal Components From a Large Number of Predictors , 2002 .

[32]  M. Woodford,et al.  INTEREST AND PRICES: FOUNDATIONS OF A THEORY OF MONETARY POLICY , 2005, Macroeconomic Dynamics.

[33]  N. Mankiw,et al.  Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve , 2001 .

[34]  M. Hallin,et al.  The Generalized Dynamic-Factor Model: Identification and Estimation , 2000, Review of Economics and Statistics.

[35]  James D. Hamilton.  Time Series Analysis , 1994 .

[36]  Anna J. Schwartz,et al.  A Monetary History of the United States, 1867-1960. , 1964 .

[37]  Ricardo Reis,et al.  Relative Goods' Prices and Pure Inflation , 2008 .

[38]  P. Zaffaroni,et al.  Can aggregation explain the persistence of inflation , 2009 .

[39]  Frederic S. Mishkin.  Is the Fisher Effect for Real? A Reexamination of the Relationship between Inflation and Interest Rates , 1991 .

[40]  Riccardo Cristadoro,et al.  A Core Inflation Index for the Euro Area , 2001 .

[41]  Robert J. Barro,et al.  Macroeconomics - 5th Edition , 1997 .

[42]  Mark W. Watson,et al.  Consistent Estimation of the Number of Dynamic Factors in a Large N and T Panel , 2007 .

[43]  Frederic S. Mishkin.  Is the Fisher Effect for Real? A Reexamination of the Relationship between Inflation and Interest Rates , 1991 .

[44]  A. W. Phillips,et al.  A. W. H. Phillips: Collected Works in Contemporary Perspective: The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957 , 2000 .

[45]  Richard G. Lipsey,et al.  The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom , 1960 .

[46]  Jean Boivin,et al.  Sticky Prices and Monetary Policy: Evidence from Disaggregated U.S. Data , 2007 .