metadata: authors: 0: author: Ha,Jongrim
1: author: Kose,Ayhan
2: author: Ohnsorge,Franziska Lieselotte
3: author: Yilmazkuday,Hakan
count: World
docna: 0: docna: Understanding the Global Drivers of
            Inflation : How Important Are Oil Prices ?
docty: Policy Research Working Paper
abstracts: cdata!: This paper examines the global drivers
            of inflation in 55 countries over 1970&#x2013;2022. The
            paper estimates a Factor-Augmented Vector Autoregression
            model for each country and assess the importance of several
            global (demand, supply, and oil price) and domestic shocks.
            It reports three main results. First, global shocks have
            explained about 26 percent of inflation variation in a
            typical economy. Oil price shocks accounted for only about 4
            percent of inflation variation, but they had a statistically
            significant impact on inflation in three-quarters of the
            countries. Second, global shocks have become more important
            in driving inflation variation over time. The share of
            inflation variance caused by oil price shocks increased from
            4 percent prior to 2000 to roughly 9 percent during
            2001&#x2013;22. They also accounted for some of the
            steep runup in inflation between mid-2021 and mid-2022.
            Third, oil price shocks tended to contribute significantly
            more to inflation variation in advanced economies, countries
            with stronger global trade and financial linkages, commodity
            importers, net energy importers, countries without
            inflation-targeting regimes, and countries with pegged
            exchange rate regimes. The headline results are robust to a
            wide range of exercises&#x2014;including alternative
            measures of global factors and oil prices&#x2014;and
            aggregation of countries.
display_title: Understanding the Global Drivers of
            Inflation : How Important Are Oil Prices ?
listing_relative_url: /research/2023/01/33986129/understanding-global-drivers-inflation-important-oil-prices
topicv3: Macro Shocks m1326058 704,Economic Growth m1326241 471,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Commodity Prices Shocks m1327185 1164
publishtoextweb_dt: 2023-01-24T00:00:00Z
dois: 10.1596/1813-9450-10283
origu: Off of Sr VP Dev Econ/Chief Econ (DECVP)
author_keys: 0: author_key: 1485696
1: author_key: 1320178
2: author_key: 1309022
3: author_key: 1382122
model_extractions: Policy Research Working Paper 10283 Understanding the Global Drivers of Inflation How Important Are Oil Prices?

_Jongrim Ha M. Ayhan Kose Franziska Ohnsorge Hakan Yilmazkuday_ Prospects Group January 2023
Policy Research Working Paper 10283

# **Abstract**

This paper examines the global drivers of inflation in 55 countries over 1970–2022. The paper estimates a Factor-Augmented Vector Autoregression model for each country and assess the importance of several global (demand, supply, and oil price) and domestic shocks. It reports three main results. First, global shocks have explained about 26 percent of inflation variation in a typical economy. Oil price shocks accounted for only about 4 percent of inflation variation, but they had a statistically significant impact on inflation in three-quarters of the countries. Second, global shocks have become more important in driving inflation variation over time. The share of inflation variance caused by oil price shocks increased from 4 percent prior to 2000 to roughly 9 percent during 2001–22. They also accounted for some of the steep runup in inflation between mid-2021 - and mid-2022. Third, oil price shocks tended to contrib ute significantly more to inflation variation in advanced economies, countries with stronger global trade and financial linkages, commodity importers, net energy importers, countries without inflation-targeting regimes, and countries with pegged exchange rate regimes. The headline results are robust to a wide range of exercises—including alternative measures of global factors and oil prices—and aggregation of countries.

This paper is a product of the Prospects Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at jongrimha@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Understanding the Global Drivers of Inflation:** **_How Important Are Oil Prices?_**

Jongrim Ha, M. Ayhan Kose, Franziska Ohnsorge and Hakan Yilmazkuday<sup>1</sup>

**_Statistically Keywords_** : Inflation; oil prices; global shock; domestic shock; FAVAR; exchange rates. **_JEL Classification_** : E31, E32, Q43

 Ha: World Bank, Prospects Group; jongrimha@worldbank.org. Kose: World Bank, Prospects Group; Brookings Institution; CEPR, and CAMA; akose@worldbank.org. Ohnsorge: World Bank, Prospects Group; CEPR; CAMA; fohnsorge@worldbank.org. Yilmazkuday: Florida International University; hyilmazk@fiu.edu. We would like to thank Zidong An, Carlos Arteta, Menzie Chinn, Kevin Clinton, Zolt Darvas, Alistair Dieppe, Laurent Ferrara, Graham Hacche, David Hendry, Gene Kindberg-Hanlon, Wee Chian Koh, Catherine Kyrtsou, David Papell, Xuguang Simon Sheng, Koji Takahashi, Christopher Towe, Kozo Ueda, Lei Sandy Ye, Kamil Yilmaz, and several seminar and conference participants for their helpful comments on earlier versions of this paper. Heqing Zhao provided excellent research assistance. We gratefully acknowledge support from World Bank PHRD and KCP Funds. The findings, interpretations and conclusions expressed in this paper are those of the authors and should not be attributed to the World Bank, its Executive Directors, or the countries they represent.
# **I. Introduction**

Changes in inflation often have been associated with fluctuations in global output and oil prices. For example, between the early 1970s and the mid-1990s, inflation rose in many advanced economies and emerging market and developing economies (EMDEs) because of jumps in oil prices, sharp movements in output, and and/or financial crises—including debt and currency crises. Conversely, declines in inflation in advanced economies and EMDEs were associated with short-lived oil price plunges in the mid-1980s and the early 1990s.

Recent developments have renewed interest in the links between oil prices and inflation. After tumbling in the early months of the COVID-19 pandemic, inflation has been climbing in many countries since the middle of 2020. The highly synchronized increase in inflation appeared to be driven by a sharp rebound in demand that followed the reopening in many countries, persistent disruptions in global supply chains, and highly volatile fluctuations in oil and food prices. Since the Russian invasion of Ukraine in February 2022, global factors, including oil prices, have become more pronounced drivers of inflation.

Against this background, we examine the roles of global drivers of inflation—including global supply, global demand, and oil price shocks—in a large sample of advanced economies and EMDEs over 1970–2022. Specifically, we address three questions. First, what have been the global drivers of inflation over the past half century? Second, how have the roles of oil prices and other global shocks changed over time? Third, how does the importance of oil price shocks depend on country characteristics?

Our paper presents the first comprehensive analysis of the roles of the global drivers of inflation for a large panel of countries over a long period. It makes three specific contributions to the literature.

First, to our knowledge, ours is the first study to examine the global sources of variation in inflation in a unified framework. We estimate a series of country-specific factor-augmented vector autoregression (FAVAR) models to quantify the roles of multiple global and domestic shocks in driving inflation. We identify these shocks using sign restrictions that are motivated by theory. Our inclusion of both global and domestic disturbances provides a rich menu of shocks, which allows us to conduct a comprehensive study of the importance of oil-price shocks in the presence of other well-known drivers of inflation.

Second, our study is the first to employ data for a large and globally diverse sample of 55 countries, including 29 advanced economies and 26 EMDEs. The large country sample helps us to identify the links between certain country characteristics and the importance of oil price shocks in driving inflation variation.

Finally, we analyze the longest quarterly data sample available over the 1970–2022 period for our country panel. Our use of a long time series allows us to consider the behavior of inflation and the roles played by different types of global shocks during multiple global recessions (1975, 1982, 1991, 2009, and 2020), periods of volatility in oil markets, and the post-pandemic period.

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Some earlier studies have also considered the roles played by various global and domestic shocks in driving inflation fluctuations. For example, Charnavoki and Dolado (2014) analyze the impact of global demand, global supply, and commodity prices on Canadian prices (among other domestic variables) using a FAVAR model, in which shocks are identified by sign restrictions (as in this paper). They report that both global demand and commodity price shocks affect Canadian prices. In a recent study, Finck and Tillmann (2022) estimate SVAR models to study the importance of global and domestic shocks in driving inflation in six emerging market economies in Asia. They report that such shocks account for a sizable share of inflation variance.<sup>2</sup> We report three major findings. First, global shocks—associated with demand, supply, and oil prices—accounted for nearly 26 percent of inflation variation in the median country over the 1970–2022 period. Demand shocks (about 18 percent) and oil price shocks (4 percent) together explained the lion’s share of inflation variance caused by the global shocks. Although the role of oil price shocks in explaining inflation variation appears to be small in a typical country, such shocks have a statistically significant effect on inflation movements in three-quarters of the countries. A positive one-standard-deviation oil price shock (close to the size of the positive oil price shock of early 2022 during the Russian invasion of Ukraine) is associated with 1.2 percentage point increase in the inflation rate in the median country after two years. The contribution of global demand and oil price shocks to inflation variance is typically much larger in advanced economies than in EMDEs.

The role of global shocks (especially global demand and oil price shocks) was more prominent in explaining changes in inflation during global recessions and periods of significant disturbances in oil markets. For example, oil price shocks contributed roughly 3.4 percentage points to the 7 percentage-point increase in year-on-year inflation, on average, between the third quarter of 1973 and the first quarter of 1974. Even in the most recent run-up in inflation, between the second quarter of 2021 and the second quarter of 2022, oil prices accounted for about one-tenth of the increase in inflation.

Second, the role of global shocks has grown over time: over the past two decades, global shocks were responsible for roughly 36 percent of inflation variation, compared to about 20 percent prior to 2000. The importance of oil price shocks has also risen from 4 percent (before 2000) to nearly 9 percent (since 2001). To a large extent, these findings may reflect the larger effect on inflation of global demand and oil price shocks, driven by the global recessions in 2009 and 2020, and multiple periods of significant volatility in global oil markets.

Third, the importance of oil price shocks in explaining inflation variation depended on country characteristics. For example, the share of inflation variance from oil price shocks tended to be statistically significantly larger for economies with stronger international trade and financial

> 2 In related work, Eickmeier and Kühnlenz (2018) employ a FAVAR model to examine the effects on inflation in 38 countries of supply and demand shocks that originate in China. They find that the shocks on average account for about 6 percent of inflation variation. An earlier study by Bianchi and Civelli (2015) uses a time-varying VAR analysis to compare the effects of global slack and domestic slack on country-specific inflation rates. They find that the effects of global slack on inflation are stable over time, but they increase across countries as the degree of trade and financial openness rises.

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linkages. Oil price shocks also played a significantly more important role in commodity (or net oil) importers. They drove a statistically significantly larger share of inflation variance in countries without inflation-targeting monetary policy frameworks, with pegged exchange rate regimes, and with a larger stock of public debt.

The rest of the paper is organized as follows. Section II presents our model, identification strategy and database. In Section III, we discuss the roles of global shocks in driving inflation variation using variance decompositions and impulse responses. In Section IV, we assess the links between the importance of oil price shocks in driving inflation and key country characteristics. Section V analyzes how global shocks affect the level of inflation, based on historical decompositions of estimated impulse response functions. In Section VI, we conduct a series of exercises to study the robustness of our headline findings. Section VII concludes with a summary of results and future research directions.

# **II. Methodology and database**

We estimate country-specific FAVAR models with three global variables—global inflation, global output growth, and global oil price growth—and four domestic variables—domestic inflation, domestic output growth, domestic interest rates, and nominal effective exchange rates. The first two global variables are proxied by common components across countries. Each of these is estimated using a single-factor dynamic factor model. The oil price is the average price of three major oil price benchmarks.

Our main variable of interest is domestic inflation. The model specification here is similar to earlier work by Forbes, Hjortsoe, and Nenova (2018, 2020) and Conti, Neri, and Nobili (2015)—which also include multiple domestic variables. However, it deviates from these studies because we also consider the effects of global supply, global demand and oil price shocks (on domestic inflation) in a unified setup. All the variables are seasonally adjusted quarterly growth rates (except interest rates) over the period 1970Q2–2022Q2.

# **II.1. FAVAR model**

In its structural form, the following FAVAR model is employed: y,global where Zt consists of global output growth ( ft ), oil price growth ( op ), global inflation ( ftπ,global ), domestic inflation ( πdomestic ), nominal effective exchange rate appreciation ( XR ), domestic output growth ( Y<sup>domestic</sup> ), and domestic nominal short-term interest rates ( interest ).

The vector εt includes the following global shocks: a shock to the global demand of goods and services (“ _global demand shock_ ”); a shock to oil prices (“ _oil price shock_ ”); and a shock to the global 4
supply of goods and services (“ _global supply shock_ ”). It also includes the following domestic shocks to: (i) the domestic supply of goods and services (“ _domestic supply shock_ ”); (ii) the nominal effective exchange rate (“ _exchange rate shock_ ”); (iii) the domestic demand of goods and services (“ _domestic demand shock_ ”); and (iv) domestic monetary policy (“ _monetary policy_ ”). Employing this rich menu of global and domestic shocks, we are able to provide a comprehensive analysis of how global shocks drive domestic inflation.

The model is estimated with two lags (identified as optimal lag length according to the SIC and AIC criteria). For each country model, the Bayesian estimation searches for 1,000 successful draws of at least 2,000 iterations with 1,000 burn-ins. In the estimation, the Minnesota priors proposed by Litterman (1986) are used. The results presented here—for instance, impulse response functions— are based on the median (50th percentile) of these 1,000 successful draws and 68 percent confidence intervals at the country level. In reporting aggregated results of the forecast error variance decompositions, we use medians across countries, but we also report the simple average and GDP-weighted averages to test the robustness of our findings in Section VI.

# **II.2. Identification of shocks**

We identify the shocks using sign restrictions as in studies by Charnavoki and Dolado (2014) and Forbes et al. (2018, 2020). Postulating that B0−1 in our model has a recursive structure such that the reduced form errors can be decomposed according to ut = B0−1εt , the sign restrictions that are imposed over the first two quarters can be written as follows: <!-- Start of picture text --> Y,global GlobalDemand<br>ut utop + + −+ ++ 00 00 00 00 εt εtOilPrice<br>GlobalSupply<br>utπ,global + + − 0 0 0 0 εt<br>utπ,domestic = ∗ ∗ ∗ − ∗ + − εtDomesticSupply<br>XR ∗ ∗ ∗ ∗ + ∗ + ExchangeRate<br>ut εt<br>Y,domestic ∗ ∗ ∗ + ∗ + − DomesticDemand<br>ut [ ∗ ∗ ∗ ∗ ∗ + + ] εt<br>interest MonetaryPolicy<br>[ ut ] [ εt ]<br><!-- End of picture text --> where * stands for an unrestricted initial response. While domestic shocks do not affect global variables contemporaneously, global shocks can affect domestic variables (without any sign or zero restrictions). These sign restrictions, which are used to identify the structural shocks, are consistent with theoretical predictions (Fry and Pagan 2011).

We next briefly discuss the motivation behind our assumed sign restrictions. Regarding the identification of _global_ shocks: a positive global supply shock (hereafter “ _global supply shock_ ”) is assumed to raise global output and oil price growth but to reduce global inflation. A positive _global demand shock_ is assumed to increase global output growth, global inflation, and oil price growth. Our identification assumptions with respect to the global supply and demand shocks are consistent with the earlier literature. A positive _oil price shock_ is assumed to raise oil prices and global inflation 5
but to lower global output growth. This set of identification assumptions on oil price shocks also closely follows some earlier studies—such as those by Melolinna (2015), Charnavoki and Dolado (2014), and Ferroni and Mojon (2014)—which presume that a positive cost (commodity price) shock reduces output and raises commodity prices and inflation.

We also closely follow the earlier literature in our assumptions with respect to the identification of _domestic_ shocks: A positive _domestic supply shock_ raises domestic output growth but reduces inflation. A positive _domestic demand shock_ is assumed to raise domestic output growth, inflation, and domestic interest rates. These sign restrictions are in line with the sign restrictions employed by Gambetti, Pappa, and Canova (2005) and Forbes, Hjoertsoe, and Nenova (2018). A contractionary (positive) _monetary policy shock_ triggers nominal effective appreciation, lowers output growth, and lowers inflation. Finally, the impact of a positive _exchange rate shock_ (corresponding to an appreciation of the domestic currency) is assumed to increase the exchange rate, while its impact on other domestic variables is left unrestricted.

# **II.3. Database**

Our country sample includes 29 advanced economies and 26 EMDEs with at least 10 years (40 quarters) of continuous data for the variables in the domestic block, although the sample period differs across countries. The full sample covers the period from 1970Q2 to 2022Q2. The list of countries and sample periods are presented in Table A1 of the Appendix.

_Global output growth_ is the estimated global factor of quarter-on-quarter, seasonally adjusted real gross domestic product (GDP) growth of all countries in our sample. _Global inflation_ is also the estimated global factor of quarter-on-quarter, seasonally adjusted headline consumer price index (CPI) inflation of the same country sample. To allow the country-specific FAVAR estimations to cover data as far back in time as possible, the global factors for output growth and inflation are estimated using country samples with available data for the full sample period 1970Q22022Q2.<sup>3</sup> Formally, global inflation and global output growth are estimated by the following two dynamic factor models: where πti and Yti are inflation and output growth in country _i_ in quarter _t_ , respectively, while π,global Y,global ft and ft are the global common factors for inflation and output growth at quarter _t_ , respectively.<sup>4</sup> _Oil price growth_ is the quarter-on-quarter growth rate of the nominal oil price (the

> 3 This restricts the sample to 29 countries for global output growth and 47 countries for global inflation (which accounted for 60 percent of global GDP in 2021). For about half of the country sample, the FAVAR estimation only starts in the 1990s.

> 4 The main assumptions in the estimation of the global factors follow those in Kose, Otrok, and Prasad (2012). The model is specified in terms of growth because the variable of interest (inflation) is itself a growth rate.

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simple average of Dubai, West Texas Intermediate, and Brent benchmarks), as reported by the World Bank’s monthly _Pink Sheet_ .

_Domestic output growth_ is quarter-on-quarter, seasonally adjusted real GDP growth, as reported by Haver Analytics and the World Bank’s _World Development Indicators_ . _Domestic inflation_ is quarter-on-quarter, seasonally adjusted headline CPI inflation, as reported in the World Bank’s _Global Database of Inflation_ (Ha, Kose, and Ohnsorge 2022). _Domestic interest rates_ are quarteron-quarter differences in three-month Treasury bill rates or monetary policy rates, as reported by Haver Analytics, the _Federal Reserve Economic Data_ (FRED) database, and the OECD’s database. The _Nominal effective exchange rate_ is the quarter-on-quarter change in trade-weighted nominal exchange rates, as reported by Haver Analytics and the IMF’s _International Financial Statistics_ .<sup>5</sup>

# **III. Role of global shocks**

# **III.1. Contributions of global shocks: Variance decompositions**

**_Contributions of global shocks._** Over the full sample period, global shocks accounted for nearly 26 percent of domestic inflation variance in the median country (see Table 1A). Domestic shocks explained the rest of the inflation variance. For the remainder of this paper, we focus our discussion on global shocks, the main interest of this study.<sup>6</sup>

Global demand shocks and oil price shocks were the main drivers of inflation in the average country, accounting for 18 and 4 percent of inflation variance, respectively, during 1970–2022. This finding is broadly consistent with earlier results reported by a few other studies (Conti, Neri, and Nobili 2015; Parker 2018). The relatively large role of global demand shocks (along with oil price shocks) in part reflected the major inflation swings around global recessions (Ha, Kose, and Ohnsorge 2021a and 2022) and around disruptive movements in oil markets in almost every decade in the last half century.

**_Contributions across countries._** The contribution of global shocks to inflation variation was, on average, considerably larger in advanced economies (35 percent) than in EMDEs (19 percent). Global demand shocks typically accounted for 25 percent of inflation variation in advanced economies and 14 percent in EMDEs. The importance of oil price shocks in driving inflation variance in advanced economies, at 6 percent, was also twice that of the 3 percent in EMDEs.

These findings likely reflect the greater homogeneity of advanced economies than of EMDEs and could be caused by a wide range of features advanced economies share—such as stronger global trade and financial linkages, deeper integration into global supply chains, and similar monetary policy regimes (see Table 1A). The similarity of monetary policy regimes, is, for example, also reflected in considerably more homogeneous inflation expectations in advanced economies than

> 5 Long-term components of quarterly growth rates are eliminated by using 15-year moving averages, following Stock and Watson (2012). The results are qualitatively robust to different detrending methods (for example, the HodrickPrescott or Butterworth filters). These robustness results are available upon request.

> 6 Detailed results on the importance of domestic shocks are available upon request from the authors.

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in EMDEs. By comparison, EMDEs constitute a more heterogeneous group of countries where inflation is often more responsive to domestic factors (Cárdenas et al., 2011; Halka and Kotlowski, 2017; Osorio and Unsal, 2013).

**_Contributions over time._** Over the three subperiods we examine (1970–85, 1986–2000, and 2001– 22), the contribution of global shocks to inflation variation has grown significantly, especially since 2001 (to 36 percent for the median country), and in all country groups (to more than one-half in advanced economies and about one-quarter in EMDEs). The larger contribution in the later period could be the result of considerably larger global demand and oil price shocks in the last subperiod (see Tables 1, Parts B and C). Specifically, the contribution of global demand shocks has increased from 11 percent in the first subperiod to 25 percent during the last subperiod, and that of oil price shocks has also risen, from 4 percent (in 1986–2000) to nearly 9 percent (in 2001–22). To a large extent, this may reflect the effect on inflation of global demand shocks driven by the global recessions in 2009 and 2020. The last subperiod has also had significant volatility in oil prices in 2007–09, 2014–16, and again in 2020–22 (Baffes et al. 2015; Nguyen et al. 2017; Ha, Kose and Ohnsorge 2022).

In contrast, the importance of global supply shocks has declined over time—from 5 percent during 1970–85 to less than 2 percent for the median country after 2001. A large number of countries were afflicted by waves of financial crises in the 1970s, 1980s, and 1990s—when steep inflation surges were accompanied by plunging output, a phenomenon we capture as supply shocks in our framework here. By comparison, the 2000s were a period of relative calm in EMDEs, notwithstanding the global financial crisis that began in 2008 (Kose et al. 2021).

# **III.2. Impact of global shocks: Impulse responses**

**_Overall impact._** The estimated impulse responses suggest that global shocks had a significant impact on inflation. For the full sample, over two years, impulse responses to global demand and oil price shocks were statistically significant for more than 70 percent of countries and to global supply shocks for more than 60 percent of countries (see Figure 1). For all three global shocks, the share of countries with statistically significant impulse responses was larger for the group of advanced economies than for the group of EMDEs.

A more detailed analysis of impulse responses confirms these initial observations. For example, a positive one-standard-deviation global demand shock (about one-third the size of the average negative demand shock of 2008–09) was associated with 0.8 percentage-point higher inflation in the median country (50th percentile) within a quarter and, cumulatively, with about 2.4 percentage-point higher inflation after two years (see Table 2, Part A and Figure 2). A negative one-standard-deviation global supply shock was followed by 0.3 percentage-point higher inflation within a quarter and, cumulatively, 0.7 percentage-point higher inflation after two years. Finally, a positive one-standard-deviation oil price shock (close to the size of the positive oil price shock of early 2022, during the Russian invasion of Ukraine) was associated with 0.3 percentage-point higher inflation in the median country within a quarter that built up to, cumulatively, around 1.2 percentage points after two years.

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**_Impact across country groups._** For the median country, the effect of global shocks on inflation was broadly similar in EMDEs and advanced economies (see Table 2, Part B). Inflation in the median country was 2.6 percentage points higher in advanced economies and 2.5 percentage points higher in EMDEs two years after a positive one-standard-deviation global demand shock. A negative onestandard-deviation global supply shock resulted in a somewhat larger increase in inflation in the median advanced economy (0.9 percentage point) than in the median EMDE (0.6 percentage point), but the estimated interquartile ranges overlap. A positive one-standard-deviation oil price shock was also associated with a somewhat larger increase in inflation in the median advanced economy (1.3 percentage point) than in the median EMDE (0.9 percentage point) but, again, the interquartile ranges overlap.<sup>7</sup>

**_Impact over time._** The impulse responses of inflation to oil price and global demand shocks during 2001–22 were comparable to those during 1970–85 but larger than those during 1986–2000. In part, this reflected the larger movements in oil prices in the mid-1970s, early 1980s, mid-2000s, and most recently 2020–22. Finally, the cumulative responses to global supply shocks were larger during 1970–85 than in later subperiods, possibly reflecting significant improvements in the overall flexibility of economies and monetary policy frameworks that facilitated faster adjustments to shocks. This result is consistent with the declining role of global supply shocks based on the variance decompositions of inflation in Section II.

# **IV. Role of oil price shocks: Country characteristics**

We now examine how the importance of oil price shocks in explaining inflation volatility varied, depending on a few key country characteristics (see Table A2 of the Appendix). Specifically, we study two types of country characteristics—one based on the nature of international linkages (see Table 3) and the other based on the nature of domestic policies (see Table 4). International linkages that we consider are commodity importer/exporter status, net oil exporter/importer status, and the extent of financial and trade openness. For domestic policies, we examine different types of monetary policy frameworks and exchange rate regimes, and the level of public debt. We formally test the significance of differences across country subgroups in the context of each country characteristic.

# **IV.1. International linkages**

_Trade integration_ is a critical factor that could transmit oil price shocks to domestic prices. Our findings portray a consistent and intuitively appealing link between trade integration and the importance of oil price shocks in explaining inflation. Specifically, for all measures of trade integration we employ, the share of inflation variance attributable to oil price shocks tends to be larger for more integrated economies. For example, in EMDEs with a higher degree of trade openness, as measured by the trade-to-GDP ratio, the inflation variance from oil price shocks was more than twice that in EMDEs with a lower degree of trade openness (see Table 3). In EMDEs with

> 7 Using a local projection model based on a panel of 72 countries, Choi et al. (2018) find similar point estimates for the effects of oil price shocks on inflation in advanced economies and EMDEs.

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a higher degree of participation in global value chains, oil price shocks contributed almost three times as much to inflation movements as they did in EMDEs with less participation. In several cases we examine (both full sample and group subsamples), the difference in the importance of oil price shocks in explaining inflation variation between more integrated and less integrated economies was statistically significant.

These findings are consistent with some earlier studies. Bianchi and Civelli (2015) report that the impulse responses of inflation to global slack are larger in countries that are more open to trade. Similarly, a theoretical model developed by Martínez-Garcia and Wynne (2010) predicts that inflation is less responsive to domestic slack in countries that are more open to trade. Andrews, Gal, and Witheridge (2018) document that a high level of global value chain integration can strengthen the transmission of global shocks by accentuating the effect of global economic slack on domestic inflation.

We also examine the role of oil price shocks in countries with different degrees of dependence on commodity and energy imports. The contribution of oil price shocks to inflation variation tended to be statistically significantly larger for commodity and net energy importers than for the full sample. This finding is also consistent with earlier studies—such as by Salisu et al. (2017)—which report that oil prices exert a greater impact on inflation in net oil importers than in oil exporters. For advanced economies, this difference was more pronounced: among advanced economies, the importance of oil price shocks in driving inflation in commodity importers was more than three times that in commodity exporters. Similarly, in EMDEs, the contribution of oil price shocks to inflation variation in net energy importers was more than twice that in net energy exporters. The larger role of oil price shocks in commodity and net energy importers is likely the result of the compounded effect of oil price movements through currency fluctuations on inflation.

Our results with respect to _financial integration_ are similar to those from trade integration in the sense that oil price shocks tended to play a larger role in explaining inflation variation in more financially integrated economies than in less integrated ones. This result holds irrespective of the financial integration measure used, and in many cases (full sample and group subsamples), the differences between more and less financially integrated economies were statistically significant. For example, in advanced economies with larger international assets and liabilities relative to GDP, the share of inflation variance from oil shocks tended to be twice that in less integrated economies. This is consistent with other studies—such as by Urom et al. (2021)—that find that financially integrated countries are more affected by monetary policies of their financial partners reacting to changes in oil prices than are less financially integrated economies.

# **IV.2. Domestic policies**

Oil price shocks tended to play a smaller role in explaining inflation variation in countries with inflation-targeting monetary policy frameworks than in those that did not target inflation. The difference was statistically significant for the full sample of countries and subsamples (see Table 4). This finding is broadly consistent with earlier studies—such as by Chen (2009)—which find that oil price shocks have a smaller effect on inflation when central banks react to higher oil prices by 10
increasing their policy rates. Other characteristics of central banks, such as central bank independence and the number of changes in central bank leadership, either did not translate into statistically significant differences with respect to the role of oil price shocks or did so only when the full sample was considered.

We also analyze the role of an exchange rate regime in explaining the importance of oil price shocks. Irrespective of the country sample and the measure of exchange rate regime employed, the importance of oil price shocks in explaining inflation variation tended to be statistically significantly larger in countries with pegged exchange rate regimes than that in countries with flexible regimes. This result implies that oil price shocks are passed through into inflation to a lesser extent when exchange rates are allowed to adjust to market forces. Finally, oil price shocks explained a larger share of inflation variance in countries with bigger stocks of government debt than in those with smaller ones. However, this difference was statistically significant only for the full sample.

# **V. Global shocks and inflation fluctuations**

After analyzing the role of global shocks in driving the volatility of inflation, we now turn to an analysis of the importance of global shocks in explaining the level of inflation. For this purpose, we compute the historical contributions of global shocks (demand, supply, and oil price) and domestic shocks to inflation using the impulse response functions estimated in the previous section (see Figure 3). We focus on the cross-country averages of these contributions and report results for the full-sample period (see Figure 3, Panel A, 1970–2022) as well as the last subperiod (see Figure 3, Panel B, 2001–22), which includes the 2009 and 2020 global recessions.

Consistent with the results of variance decompositions of inflation discussed in Section III, domestic shocks (gray-colored) explain the bulk of fluctuations in inflation during most of the full sample period (see Figure 3, Panel A). However, during global recessions and periods coinciding with major movements in oil prices, the importance of global shocks—in particular, global demand and oil price shocks--rises. For example, global demand shocks (blue-colored) play a significant role in explaining movements in inflation (both its rise and fall) during the global recessions of 1975, 1982, and 1991. These shocks became more important in explaining inflation movements during the 2009 and 2020 global recessions.

Oil price shocks (red-colored bars) play an important role during the two oil crises (1973–74 and 1979). For example, oil price shocks contributed about one-half of the 7 percentage-point increase in year-on-year inflation, on average, between the third quarter of 1973 and the first quarter of 1974. They accounted for about a quarter of the 5.4 percentage-point increase in inflation during 2007–08. Similarly, when oil prices plunged between mid-2014 and January 2016, they again played a sizable role in the decline in inflation, explaining about half of the 1.3 percentage-point decline in year-on-year inflation, on average, between the second quarter of 2014 and the first quarter of 2016. Although the role of global supply shocks (orange-colored bars) was smaller than that of global demand and oil price shocks, they did play a role during a few episodes— including the disruptions that followed the oil price spikes in the 1970s and in global recessions.

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Global demand shocks have been the main force triggering the collapse of inflation in the first half of 2020. They fully accounted for the decline in year-on-year inflation, on average, between the fourth quarter of 2019 and the second quarter of 2020. These demand shocks began to unwind in the second half of 2020, on the back of a strong demand rebound from the global recession, a recovery that was in part fueled by substantial policy support. Price increases were particularly large in sectors in which pent-up demand picked up after the reopening from the pandemic while capacity constraints and supply chain disruptions persisted.

Since the second half of 2021, and in particular following the Russian invasion of Ukraine in early 2022, the drivers of inflation pressures have broadened. Global demand shocks, in part reflecting the release of pent-up demand, accounted for about a fourth of the 6.5 percentage-point increase in year-on-year inflation, on average, between the second quarter of 2021 and the second quarter of 2022; global supply shocks, such as shipping bottlenecks and wage pressures in some countries, accounted for a fifth of the increase; the rebound in global oil prices for a tenth. These findings are broadly consistent with empirical results reported by di Giovanni et al. (2022), Shapiro (2022), and Ha, Kose, and Ohnsorge (2022).

# **VI. Robustness exercises**

In this section, we present a set of exercises to check the robustness of our headline results: (i) using real oil prices and nominal energy prices as alternatives to nominal oil prices; (ii) using alternative measures of global output growth and global inflation; and (iii) presenting variance compositions based on the simple averages and weighted averages across countries (as an alternative to using medians). The results from these exercises are broadly in line with our headline results (see Table 5).

# **VI.1. Oil prices**

Our baseline exercises employ growth of nominal oil prices. We replace them here with two alternative price series: (i) growth of real oil prices, and (ii) growth of nominal energy prices.<sup>8</sup> The corresponding measures are depicted in Figure 4, where they are shown to be very similar. In the baseline exercise, oil price shocks account for about 4 percent of inflation variance. When the alternative measures are used in estimations, the share is around 6 percent.

# **VI.2. Global output growth and global inflation**

We proxied global output growth and global inflation with common global factors in our baseline exercises. Alternatively, they can be based on the: (i) median of, and (ii) weighted average across countries. These alternative measures move closely with our global factor estimates (see Figure 4). While these new measures do not affect the relative importance of global supply and oil price shocks in explaining inflation variance, they translate into a somewhat larger role for global

> 8 Nominal oil and energy prices are based on the series from the World Bank’s Pink Sheet data. Real oil prices are obtained by deflating nominal oil prices with the U.S. Consumer Price Index. The nominal energy price is an index that includes crude oil prices, natural gas prices, and coal prices.

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demand shocks. Nevertheless, the difference of this larger role (with respect to the baseline results) is not statistically significant.

# **VI.3. Aggregation methods**

We used medians of variance shares across countries when we reported our baseline results. Instead, we now compute the simple averages and GDP-weighted averages of variance shares. Our baseline variance decompositions of inflation are robust to these alternative aggregations. We also check how the baseline results for country groups and subperiods change when we introduce alternative aggregation methods. While the specific magnitudes change, the main trends are consistent with our baseline results. First, global shocks tend to have a more important role in advanced economies than in EMDEs. Second, the role of global demand shocks has more than doubled between the first and third subperiods while the role of global supply shocks has more than halved and the role of oil price shocks has risen slightly.

# **VII. Conclusion**

Recent developments have renewed interest in the role of global factors in driving the rapid surge in inflation. In this paper, we systematically explored the roles played by a rich menu of global and domestic shocks in explaining inflation fluctuations using a FAVAR model applied to 55 countries over the 1970–2022 period. We paid special attention to oil price shocks because gyrations in oil markets have become increasingly more prominent in driving inflation since the beginning of the COVID-19 pandemic.

Our results indicate that global shocks play an important role in driving inflation. These shocks explain nearly 26 percent of inflation variation in a typical economy. Oil price shocks account for 4 percent of inflation variance, but they have a significant impact on inflation movements in three quarters of countries. The importance of oil price shocks has increased over time. These shocks are significantly more important in driving inflation variation in: advanced economies, countries with stronger global trade and financial linkages, commodity importers; net energy importers, countries without inflation targeting regimes, and countries with pegged exchange rates. We conduct a variety of additional exercises and document that our baseline results are robust to variations in global factors, oil prices, and aggregation methodologies.

Our findings suggest several topics for future research. First, we document that oil price shocks tend to be less important in driving inflation in countries that target inflation. This is an intuitively attractive observation that suggests that these central banks mainly focus on the inflationary impact of demand and supply shocks rather than on commodity price shocks, which tend to have relatively smaller and less persistent effects on core inflation. It would be useful to analyze the role of oil price shocks in driving inflation in a dynamic stochastic model that allows a central bank to employ different types of monetary policy frameworks. This type of model could strengthen the intuition behind the observation we document here. Second, because our study focused on global shocks, we did not analyze the role of domestic shocks. We plan to explore the importance of these shocks in a subsequent study.

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