TOMMASO MONACELLI

LUCA SALA

The International Dimension of Inflation: Evidence

from Disaggregated Consumer Price Data

We estimate the contribution of international common factors to the dynam-

ics of price inflation rates of a cross-section of 948 CPI products in four
OECD countries: United States, Germany, France, and United Kingdom.
We find two main results. First, on average, and at least in the sample 1991–
2004, one international common factor explains between 15% and 30% of
the variance of consumer prices (depending on the transformation applied to
the data). Given the high level of disaggregation of our panel, this estimate
is best viewed as a lower bound for the contribution of international factors
to inflation dynamics. Second, we find a strongly positive and statistically
significant relationship between exposure of consumer inflation to interna-
tional shocks and trade openness at the sectoral level. The latter result holds
regardless of whether the original data are expressed in local as opposed to
common currency.

JEL codes: E3, E32, F2

Keywords: globalization, inflation, disaggregated consumer prices.

“The integration of rapidly industrialized economies into the global trading system
clearly has had important effects on the prices of both manufactures and commodities,
reinforcing the need to monitor international influences on the inflation process.”1

HAS INFLATION BECOME more globalized? Recently this ques-

tion has attracted substantial interest among monetary policymakers. A popular tenet

1. Federal Reserve Chairman Bernanke’s remarks at 4th Economic Summit, Stanford Institute for
Economic Policy Research, Stanford, CA, March 2, 2007.
Prepared for the JMCB-Fed Board Conference “Domestic Prices in an Integrated World Economy,”
Washington, DC, September 27–28 2007. We thank Alessandro Notarpietro for his excellent research
assistance. We thank Christian Broda, Mario J. Crucini, Ken West, and two anonymous referees for useful
comments on an earlier draft. We are grateful to Benoit Mojon for providing the price data for France, and
to Domenico Giannone and Roman Liska for useful discussions and insights.
TOMMASO MONACELLI is from IGIER, Università Bocconi and CEPR, Italy (URL:
http://www.igier.uni-bocconi.it/monacelli). LUCA SALA is from IGIER, Università Bocconi, Italy
(URL: http://www.igier.uni-bocconi.it/sala).
Received October 31, 2007; and accepted in revised form September 3, 2008.
Journal of Money, Credit and Banking, Supplement to Vol. 41, No. 1 (February 2009)

C 2009 The Ohio State University
102 : MONEY, CREDIT AND BANKING

is that the increased degree of trade integration among the industrialized economies
makes it likely that international factors play a significant role in determining na-
tional inflation rates. As emphasized by Bernanke (2006), the link between trade
integration and inflation may work via two complementary channels: a direct (terms
of trade) effect due to lower import prices, and an indirect (pro-competitive) effect
due to competitive pressures, lower markups, and strategic complementarity (reduced
pricing power of domestic firms). 2 From a monetary policy perspective, if global in-
fluences are indeed important, it is conceivable that domestic inflation rates may (at
least partly) escape the control of national central banks.
The purpose of this paper is twofold. First, we aim at providing a quantitative
assessment of the relative contribution of aggregate international factors (shocks) in
driving the inflation rates of a large cross-section of disaggregated consumer prices in
four Organisation for Economic Co-operation and Development (OECD) countries.
For this purpose, we construct a measure of international commonality at the product
level, defined, for each inflation series, as the share of the variance attributable to
purely international common factors. We find that, on average, and in the sample
1991–2004, international common factors explain between 15% and 30% of the vari-
ation in disaggregated consumer price inflation rates. Given the highly disaggregated
composition of our panel, we interpret these numbers as a sizeable lower bound for
the contribution of global forces to the dynamics of disaggregated sectoral prices.
Second, we test empirically the relationship between international commonality
and sectoral trade openness. The latter is defined (for each sector in our cross-section)
as the share of imports and exports in sectoral output, respectively, from and toward
the countries of our sample. We find a strongly positive and statistically significant
relationship between international commonality of inflation and sectoral trade open-
ness, providing support for the (business-cycle) link between trade integration and
exposure of inflation to global forces.
A research literature focusing on the global dimension of inflation has developed
only recently. This literature is the counterpart of an already well-developed literature
on the international synchronization of business cycles (namely synchronization in
GDP growth fluctuations) (see Kose, Otrok, and Whiteman 2003, IMF WEO 2006,
ch. 4). Wang and Wen (2007) find that the average cross-country correlation of infla-
tion in industrialized countries is much larger than the cross-country correlation of
output growth. Borio and Filardo (2006) point the attention to “global slack” as a deter-
minant of national inflation rates. 3 Ciccarelli and Mojon (2007) argue that, historically,

2. Kamin, Marazzi, and Schindler (2006) find empirical support for the terms-of-trade effect. They
estimate that trade with China has reduced annual import price inflation in the United States by 1% per
year during 1992–2002. On the other hand, Chen, Imbs, and Scott (2004) find empirical support for the
procompetitive effect. See also Yellen (2006) on similar themes, also broadening the view to include a
potential role for increased substitutability of the labor input across countries.
3. Ihrig et al. (2007) argue against the “global-slack view” of Borio and Filardo (2006), and, in general,
against the effects of globalization on inflation. Their approach is quite different, though, and consists in
estimating, for a number of countries, a traditional (i.e., backward-looking) Phillips curve in which the
output gap is the driving force of inflation. Guerrieri et al. (2008, henceforth GGL) estimate instead a
structural Phillips curve, derived from a choice-theoretic open economy model, in which import prices
emerge as a driving factor of equilibrium markups. GGL find that the relative price of imports is an
important determinant of the inflation process for traded goods.
 TOMMASO MONACELLI AND LUCA SALA : 103

inflation in industrialized countries has been largely a global phenomenon. They esti-
mate that the CPI inflation rates of a large sample of OECD countries have a common
factor that alone accounts for nearly 70% of their variance. Mumtaz and Surico (2007)
compare the role of national versus international factors in driving the dynamics of in-
flation in a sample of industrialized countries. They conclude that while international
factors have proved particularly important in reducing the level and the persistence
of the inflation process in those countries, the increased volatility of inflation of the
seventies was by and large a country-specific phenomenon.
All aforementioned contributions addressing the general theme of globalization
and inflation share a common element: they look at aggregate price inflation data. 4
By contrast, in this paper, we test for the presence of common international compo-
nents driving the inflation dynamics of highly disaggregated consumer price data.
In particular, our data set consists of product-category monthly price series covering
the CPI in a sample of four industrialized countries: United States, Germany, France,
and United Kingdom. By product category, we mean a level of disaggregation higher
than sectoral price data but lower than individual scanner data.
Looking at product-category data yields several potential advantages. First, it allows
to explore the relationship between international commonality and economic charac-
teristics of the sector. In this work we focus, in particular, on the role of sectoral trade
openness. Second, it allows to balance the information of a rich cross-section with a
sizeable time series dimension. Both features are in fact quite relevant to our analysis,
and cannot be usually combined in panel data obtained from (even more disaggre-
gated) individual scanner observations (see, e.g., Bils and Klenow 2004, Nakamura
and Steinsson 2006, Kehoe and Midrigan 2007). Third, it allows to compute a lower
bound for the contribution of international factors to the variance of consumer product
inflation rates. That contribution is in fact sensitive to the degree of (dis)aggregation
present in the sample, with more aggregate data boosting the role of common com-
ponents in general. This feature most likely rationalizes the result found by Ciccarelli
and Mojon (2007) with aggregate CPI inflation data.
We first estimate a linear dynamic factor model applied to a cross-section of 948
consumer prices expressed in local currency, and extract those factors that are common
to the international panel (see, e.g., Forni et al. 2000). One can think of common
factors as encompassing all those unobserved aggregate components that drive the
co-movement of prices across countries, ranging from variations in policy to real and
nominal aggregate shocks (and including, potentially, also the cross-country spillover
effects of country-specific shocks). We reach the following conclusions. First, one
international common factor explains, on average, between 15% and 30% of the
variance of the consumer product inflation rates, with this range depending on the
type of transformation applied to the data, i.e., month-on-month as opposed to year-
on-year log changes (m.o.m. and y.o.y. henceforth). Our result contrasts sharply with
the one of Ciccarelli and Mojon (2007), who estimate that one common factor alone

4. An exception is Altissimo, Mojon, and Zaffaroni (2007), who, however, focus their attention on
three European countries. Except for France, our cross-section differs from theirs.
104 : MONEY, CREDIT AND BANKING

accounts for 70% of the variance of aggregate CPI inflation in a sample of OECD
countries. This contrast suggests that, in general, aggregation matters when it comes
to estimating the contribution of common factors to the total variance of a panel. Since
the cross-section we employ in this study is large and our data are significantly more
disaggregated, our estimate should be best viewed as a lower bound for the role of
international factors in driving the variations of consumer price inflation.
Second, the contribution of international common factors varies across countries:
it is the lowest in the United States (between 9 and 16%) and the highest in Germany
(between 20% and 42%).
Third, the degree of international commonality of sectoral inflation is positively and
significantly related to the trade intensity of the sector. We define the latter as the sum of
sectoral imports and exports (relative to sectoral output), respectively, from and toward
the countries of our sample. Our results indicate that, on average, a 1% increase in
sectoral trade intensity leads to an increase in the degree of international commonality
of the sector between 0.21% and 0.5%, depending on the data transformation applied
(m.om. and y.o.y. log changes, respectively).
Fourth, the type of currency transformation matters for the size of the international
commonality ratio. When we convert all data to a common currency (the U.S. dollar)
we find that the average commonality ratio rises substantially: under m.o.m. log-
changes, from 15% (under local currency) to 62% (under common currency); under
y.o.y. log changes, respectively, from 30% to 64%.
This is hardly surprising: given that nominal exchange rates are significantly more
volatile than product-category inflation rates (and especially during our sample), con-
verting to a common currency leads, for some countries, to a large amplification of
the international common component. In practice, the nominal exchange rate acts as a
highly volatile common component which becomes overwhelming relative to the con-
tribution of any idiosyncratic component. This is especially the case for Germany and
France, whose nominal exchange rates against the U.S. dollar have followed similar
dynamics during the span of our sample. Interestingly, however, our aforementioned
result on the effect of trade intensity on international commonality are not affected
by the currency transformation, although the size of the effect is amplified.
Finally, we find that the role of international factors for inflation dynamics is par-
ticularly pronounced at low and business-cycle rather than at high frequencies. More
specifically, by low and business-cycle frequencies we mean cyclical fluctuations with
a period not shorter than 1 year. Hence, from our estimates, the impact of international
factors on consumer price variations does not appear to be a phenomenon displaying
its effects in the (very) short run. This result seems consistent with our previous one
indicating that trade intensity displays larger effects on yearly rather than monthly
inflation rates.
The remainder of the paper is as follows. In Section 1, we provide some details
and summary statistics about our data set. In Section 2, we describe our empirical
methodology. In Section 3, we present the baseline results. Section 4 discusses in-
ternational commonality and trade openness. Section 5 reports results based on a
common-currency transformation. Section 6 reports results obtained in the frequency
domain. Section 7 concludes.
 TOMMASO MONACELLI AND LUCA SALA : 105

TABLE 1
SIZE OF CROSS-SECTION AFTER CORRECTIONS (1991:1–2004:1)

All Goods Services Energy/food

U.S. 260 81 139 40

Germany 448 236 49 163
France 133 58 33 42
UK 107 20 20 67
Total 948 395 241 312

SOURCES: U.S.: BEA; Germany: Office for National Statistics and Bundesbank; France: INSEE; UK: Office for National Statistics.

1. DATA SET AND SUMMARY STATISTICS

We collected a large cross-section of monthly price indexes covering the CPI for
four countries: United States, Germany, France, and United Kingdom. For the United
Kingdom we used the Retail Price Index (RPI) instead of the CPI. Price series are
included at a level of disaggregation that we label product category. This is a level
of disaggregation higher than the one of sectoral price data but lower than individ-
ual scanner data. To provide an example from the largest cross-section (the one of
Germany), the category “food” includes product series such as “egg ravioli,” “yogurt
with fruit addition,” and “sweet almonds.” In the country with the narrowest cross-
section (United Kingdom), the same food category includes products such as “fish,”
“cereals,” and “home-killed lamb.” In the case of France and Germany, the classi-
fication follows explicitly the Classification of Individual Consumption by Purpose
(COICOP) categories.
The complete data set contains 948 monthly series of consumer product prices.
The common sample across countries is 1991:01–2004:01. The sample was chosen
to guarantee homogeneity across countries and to exclude series with missing observa-
tions. We seasonally adjusted the data with the TRAMO-SEATS routine and cleaned
from outliers. Table 1 summarizes the size of the cross-section across countries and
across three relevant sectors: (i) food/energy, (ii) goods, and (iii) services.
In the appendix (not for publication) we provide all the remaining details about the
composition of each national data set. 5 Table 2 provides summary statistics on the
volatility and persistence of both aggregate inflation and disaggregated price inflation.
The degree of persistence is measured by the autoregressive coefficient computed from
an estimated AR(1) model for each individual inflation series (including a constant).
The content of Table 2 suggests at least four observations. First, in all countries
of our sample, disaggregated price inflation is on average extremely more volatile
than aggregate CPI inflation (see also Boivin, Giannoni, and Mihov 2007). Second,
consumer price inflation is not necessarily more persistent at the aggregate level than
at the individual product level. This feature contrasts sharply with the conventional

5. This appendix is available at http://www.igier.unibocconi.it/monacelli.

106 : MONEY, CREDIT AND BANKING

TABLE 2
VOLATILITY AND PERSISTENCE OF INFLATION SERIES

St. deviation (in %) Persistence

Mean 5th 50th 95th Mean 5th 50th 95th

U.S.
Aggregate CPI 0.07 0.11
Disaggregated series All 0.59 0.11 0.40 1.66 0.14 −0.21 0.13 0.54
Food/energy 0.83 0.08 0.51 3.20 0.02 −0.30 −0.06 0.47
Goods 0.64 0.21 0.56 1.51 0.22 −0.016 0.19 0.61
Services 0.49 0.09 0.30 1.47 0.09 −0.29 0.03 0.58
Germany
Aggregate CPI 0.14 0.11
Disaggregated series All 0.53 0.14 0.22 2.06 0.20 −0.08 0.18 0.59
Food/energy 1.02 0.16 0.29 4.48 0.17 −0.06 0.14 0.47
Goods 0.21 0.13 0.19 0.31 0.19 −0.33 0.19 0.58
Services 0.45 0.16 0.25 1.37 0.26 −0.13 0.25 0.64
France
Aggregate CPI 0.09 0.13
Disaggregated series All 0.39 0.14 0.25 1.27 0.17 −0.12 0.16 0.54
Food/energy 0.56 0.17 0.30 2.92 0.16 −0.25 0.14 0.54
Goods 0.29 0.13 0.24 0.85 0.15 −0.27 0.14 0.60
Services 0.34 0.14 0.26 0.96 0.21 −0.22 0.25 0.63
UK
Aggregate CPI .17 0.09
Disaggregated series All 1.89 0.18 0.77 6.34 0.14 −0.21 0.13 0.54
Food/energy 2.69 0.23 1.41 11.57 0.07 −0.22 −0.02 0.50
Goods 0.50 0.26 0.41 0.78 0.25 −0.06 0.23 0.68
Services 0.60 0.13 0.31 2.83 −0.04 −0.34 −0.09 0.38

NOTES: Sample 1991:1–2004:1, size of cross-section for each country and sector based on Table 1.

wisdom as well as with the evidence reported in Boivin, Giannoni, and Mihov (2007)
for the United States. The main difference with the latter study, though, concerns
the time series extension of the sample: while our sample starts in 1991:1, Boivin,
Giannoni and Mihov’s sample starts in 1976:1. As already pointed out in several
studies, in fact, inflation persistence has declined considerably in the last 15 years
in many industrialized countries (see, e.g., Benati 2008). Thus our data indicate that
low persistence is a feature of both the aggregate CPI and of its disaggregated com-
ponents. This alignment between aggregate and disaggregated persistence contrasts
also with the view of Altissimo, Mojon, and Zaffaroni (2007), who claim that persis-
tence in aggregate inflation may reflect an aggregation bias due to the high degree of
heterogeneity in the persistence of the disaggregated components of the CPI. 6
Third, the food/energy sector is the major contributor to the heightened volatility of
disaggregated data. This contribution is particularly relevant for the United Kingdom.

6. One way to reconcile our evidence with the one of Altissimo, Mojon, and Zaffaroni (2007) is that
the degree of heterogeneity in the persistence of the disaggregated CPI components has itself declined over
time. We cannot analyze this issue here due to the constraints of the time series dimension of our sample,
but this hypothesis is definitely worth inspecting in future work.
 TOMMASO MONACELLI AND LUCA SALA : 107

Fourth, inflation volatility in disaggregated data is generally higher in the ser-

vice sector than in the goods/manufacturing sector, with the exception of the United
States.

2. FACTOR MODEL

We are interested in estimating the absolute contribution of purely international

factors to the variation in product category inflation rates. Let n c denote the number
of countries and n j the number of price inflation series in country j, so that j = 1,
2, . . . , n c . Denote by  t the (nj nc ) × 1 vector of disaggregated inflation series of all
countries considered simultaneously, with π ij,t being the typical entry denoting the
inflation series of product category i in country j.
We estimate a model for the international panel:

t = (L)It + εt , (1)

where I t is a (q I × 1) vector of factors that are common to the whole international

cross-section, (L) is a (nj nc ) × q I matrix polynomial, and ε t is a (nj nc ) × 1 vector
of residuals. If nj nc is large enough, the space spanned by I t in equation (1) can
be estimated without parametric assumptions on the length of the filter (L) by
extracting the first q I dynamic principal components from the spectral density of the
standardized version of  t . 7

3. BASELINE RESULTS

In this section we present our baseline results, obtained by integrating over frequen-
cies. Later, and in order to explore the robustness of our analysis across frequencies,
we will present results based on a frequency domain decomposition.

3.1 How Many Factors?

When estimating (1) we confront the problem, typical in the literature, of select-
ing the number of factors q I . We use the information criterion developed in Hallin
and Liska (2007) (HL henceforth) for the determination of the number of factors in
generalized dynamic factor models. The HL criterion selects the number of factors
by trading off the explanatory power of one additional factor with a penalty term
introduced to avoid overfitting.
Formally the HL test estimates the number of factors q of a generic panel as:

q̂ = arg min I C N ,T,c (k),

0≤k≤qmax

7. Dynamic principal components are principal components computed at each frequency (see Brillinger
1981 for a thorough analysis). For technical assumptions and proofs, see Forni et al. (2000).
108 : MONEY, CREDIT AND BANKING

US GER
0.2 0.2

% of variance explained
0.15 0.15

0.1 0.1

0.05 0.05

0 0
1 2 3 4 1 2 3 4

FRA UK
0.2 0.2
% of variance explained

0.15 0.15

0.1 0.1

0.05 0.05

0 0
1 2 3 4 1 2 3 4
n. of factors n. of factors

FIG. 1. Percentage of Variance (Vertical Axis) of Each Country’s Panel Explained by the First qI (Horizontal Axis)
International Common Factors.

NOTE: Sample size as from Table 1.

where the relevant information criterion is

 
1  N
1 MT
I C N ,T,c (k) ≡ log λ̂ j (θl ) + kcp1 (N , T ).
N j=k+1 2MT + 1 l=−MT

In the above expression, N is the cross-sectional dimension, T is the time-series

dimension, 2M T + 1 is the size of the window in the lag window estimator of the
spectral density of the panel, λ̂ j (θl ) is the jth largest eigenvalue of the estimated
spectral density matrix at frequency θ l , c is a constant chosen following Section 4
(“A Practical Guide to the Selection of q”) of HL (which the reader is referred to for
details), θ l = πl/(M
√ T + 1/2), and p 1 (N , T ) is a penalty term. In our applications
8

we set MT = .75 T = 10 (as suggested in HL) and q max = 15. The HL criterion
points to the existence of only one dynamic factor driving the international panel. We
therefore set q I = 1 in (1). 9
Figure 1 gives a visual characterization of the above result. It displays the con-
tribution of the first four dynamic principal components, estimated from (1), to the
variance of the normalized panel country by country.

8. In particular the penalty term reads:

    
p1 (N , T ) = MT−2 + MT1/2 T −1/2 + N −1 log min N , MT , MT−1/2 T 1/2 .
9. Altissimo, Mojon, and Zaffaroni (2007) report results similar to ours for the importance of the first
principal component in explaining the lion’s share of the variance of a dynamic panel of disaggregated
inflation series for three European countries.
 TOMMASO MONACELLI AND LUCA SALA : 109

1
US
GER
0.9 FRA
UK

0.8

0.7

0.6
mean 0.1505

0.5

0.4

0.3

0.2

0.1

0
0 100 200 300 400 500 600 700 800 900

FIG. 2. International Commonality Ratio: Ratio of the Variance of the First International Component to the Raw Variance
of Each Series (m.o.m. log Changes, All Countries).

Figure 1 suggests that, for each country, the percentage of variance explained by the
first common component ranges between 10% and 20%, and that additional factors
explain a negligible fraction of the variance. This is consistent with the result of the
HL test previously described and points to the existence of one factor common to the
international panel.

3.2 The Role of International Macroeconomic Factors

We begin by investigating the following question: how important in absolute
terms is the international factor in driving the volatility of the disaggregated in-
flation rates? Fitting the factor model (1) on a panel composed by “blocks”
(in our case countries), the estimated number of factors represents the sum of
the number of international factors and of country-specific factors (see Hallin
and Liska 2008). The residual is the part that does not comove neither among
the blocks, nor within each block. In our case, given q I = 1, we can con-
clude that the only factor is international and that there are no country-specific
components.
International commonality ratio. Figure 2 displays, for each individual series, the
value of the international commonality ratio, σ ij , defined as the percentage of variance
explained by the common international factor. At this stage, each inflation series
110 : MONEY, CREDIT AND BANKING

1
y.o.y log changes US
GER
0.9 FRA
UK

0.8
mean 0.317

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
0 100 200 300 400 500 600 700 800 900

FIG. 3. International Commonality Ratio: Ratio of the Variance of the First International Component to the Raw Variance
of Each Series (y.o.y. log Changes, All Countries).

π ij,t is computed as month-on-month (m.o.m) log-change. The thick horizontal line

measures the mean value of this ratio.
The figure suggests two basic observations. First, the international factor accounts
on average for 15% of the volatility of the disaggregated inflation series belonging to
the panel. Second, there is substantial heterogeneity in this ratio across category of
products. For some individual series the international factor accounts for about 70%
of the volatility, whereas for some series this ratio is close to zero (see more below).
It will be important for our purposes later to take advantage of this cross-sectional
variation.
Figure 3 displays commonality ratios when the inflation rates π ij,t are computed as
year-on-year log-changes. This transformation is likely to dampen the contribution of
the idiosyncratic component to the total volatility of each series, thereby boosting the
contribution of the common component. Indeed, under this alternative transformation,
the average commonality ratio exactly doubles, rising to 30%. In this case, common
factors that are purely international explain quite a sizable fraction of the variance,
despite, again, the large dispersion in the cross-section.
Table 3 shows that the average contribution of international factors to the vari-
ance of product category inflation rates changes substantially across countries: for
instance, it more than doubles when comparing Germany with the United States, a
feature that squares well with the observation that the degree of trade openness of the
 TOMMASO MONACELLI AND LUCA SALA : 111

TABLE 3
INTERNATIONAL COMMONALITY RATIO BY COUNTRY

U.S. Germany France UK

m.o.m log changes 0.09 0.2 0.15 0.10

y.o.y log changes 0.17 0.43 0.32 0.19

NOTE: The international commonality ratio measures for each series π ij,t the percentage of variance explained by the common international
factor.

100 100

90 90

80 80

70 70
relative frequency

relative frequency

60 60

50 50

40 40

30 30

20 20

10 10

0 0
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8 1
commonality ratio commonality ratio

FIG. 4. Distribution of the International Commonality Ratio under Alternative Data Transformation (m.o.m vs. y.o.y
log changes).

NOTE: The commonality ratio is the percentage of variance explained by the common international factor for each series.

German economy far exceeds the one of the U.S. economy. Interestingly, the United
States emerge as the country in which product category inflation rates are driven by
international common factors to the least extent. Later we will explore more sys-
tematically the relationship between openness and international commonality at the
sectoral level.

Distribution of commonality ratios. Our results show substantial heterogeneity in the

distribution of the commonality ratios. Figure 4 plots, for each type of transformation
of the data, the histogram of the commonality ratio. We see that while under the
m.o.m transformation the distribution is quite skewed to the left, it tends to become
significantly more uniform when the y.o.y log-change transformation is applied. This
112 : MONEY, CREDIT AND BANKING

TABLE 4
INTERNATIONAL COMMONALITY RATIOS EXCLUDING COUNTRIES

Average no. U.S. Average no. U.S. and no. UK

m.o.m log changes 0.18 0.19

y.o.y log changes 0.38 0.41

NOTE: The international commonality ratio measures for each series π ij,t the percentage of variance explained by the common international
factor.

is further confirmation of the fact that the y.o.y. log-change transformation works in
the direction of dampening the contribution of the idiosyncratic component in each
series.
Sampling the countries differently. The share of total variation attributable to interna-
tional common components may be sensitive to the countries included in the sample.
In Table 4 we report average commonality ratios computed in two cases: (i) the case in
which the United States is excluded from the sample and (ii) the case in which both the
United States and the United Kingdom are excluded from the sample. Compared to
our results above, and not surprisingly, average commonality ratios tend to rise when
we exclude either the United States or both the United States and the United King-
dom. Those countries were in fact displaying the lowest average commonality ratios
when the factor model was estimated over the full sample of countries. Although this
evidence suggests that the cluster of France and Germany features a higher degree
of commonality, excluding either the United States or the United Kingdom does not
alter the bulk of our results on the absolute contribution of international factors to the
variation of inflation.
Summary and the role of aggregation. Our main result so far is that international
factors account, on average, for a share of the total variation in product category
inflation rates that varies between 15% and 30% (depending on whether variations
are computed on a m.o.m as opposed to y.o.y. basis), with this estimate varying in
turn across countries and across sectors. Thus our assessment of the role of interna-
tional factors for inflation dynamics contrasts sharply with the one obtained in studies
employing aggregate data, such as, for instance, Ciccarelli and Mojon (2007). The
latter study estimates that the aggregate CPI inflation rates of a large sample of OECD
countries have a common factor that alone accounts for nearly 70% of their variance.
It is evident that aggregation matters.
In light of the large cross-section employed in our study, however, our estimated
absolute contribution of international factors to inflation dynamics should be best
viewed as a lower bound. Since the study of Ciccarelli and Mojon (2007) employs
aggregate data and computes inflation rates as y.o.y log changes (i.e., it applies the
data transformation that makes international commonality more likely), their estimate
may be instead considered as an upper bound for the contribution of international
factors to inflation dynamics.
 TOMMASO MONACELLI AND LUCA SALA : 113

4. INTERNATIONAL COMMONALITY AND TRADE OPENNESS

The debate on the link between globalization and inflation has often emphasized
that increased trade integration may have played an important role in reducing both the
level and the volatility of inflation in the whole spectrum of industrialized countries.
Bernanke (2006) argues that the link between trade globalization and inflation may
work via two complementary channels: a direct (terms of trade) effect due to lower
import prices, and an indirect (procompetitive) effect due to competitive pressures,
lower markups, and strategic complementarity (reduced pricing power of domestic
firms). Recently Guerrieri, Gust, and Lopez-Salido (2008) show that foreign compe-
tition plays an important role in accounting for the behavior of inflation in the traded
goods sector. They derive an open-economy version of the so-called New Keynesian
Phillips Curve (see Galı́ and Gertler 1999) in a model in which international relative
price movements exert a competitive pressure via an endogenous effect on equilib-
rium markups (which in turn are time varying due to the presence of a nonconstant
elasticity of demand for traded goods). Hence, an interesting aspect, in our context,
concerns whether average commonality ratios vary systematically across sectors as a
function of the degree of tradability of the good(s) produced in any given sector.
To measure tradability, we collected (for the four countries in our sample) data on
bilateral trade flows for 24 sectors from the OECD STAN Bilateral Trade Database,
which contains annual data on imports and exports for the sectoral classification of
the STructural ANalysis (STAN) Database.
Recall that our measure of commonality ratio σ ij has been computed at the level of
product category i in each country j. The sectoral classification in the Bilateral Trade
Database, however, is at a more aggregate level than our original product category
classification for which we have price data available. Hence, we first matched the
original product-category classification with the STAN sectoral classification. 10 The
product-category price series that we had originally classified in the service sector
were excluded because the observed measure of trade intensity is zero.
After mapping the product-category and the sectoral classification, we constructed
the average sectoral commonality ratio in sector s as:

σs j = n −1
sj σ ji ,
i

where n sj is the number of product-category price series belonging to sector s in

country j.
Table 5 displays the STAN sectoral classification and the average commonality
ratio for each sector σ sj , with the corresponding number of product-category series
n sj in parentheses. Clearly, commonality ratios vary substantially also at the sectoral
level, and not only at the product-category level as established thus far.

10. A table containing the mapping between the original product-category classification in our data set
and the sectoral classification of the Stan Database is available in an appendix, not for publication.
114 : MONEY, CREDIT AND BANKING

TABLE 5
STAN SECTORAL DECOMPOSITION AND COMMONALITY RATIO BY SECTOR

σ sj (n sj in parentheses)
Sector U.S. GER FRA UK

Agriculture, hunting, forestry and fishing 0.009 (1) 0.053 (5) 0.092 (3)
Food products, beverages and tobacco 0.061 (22) 0.153 (154) 0.063 (38) 0.081 (64)
Textiles, textile products, leather and footwear 0.058 (13) 0.276 (66) 0.178 (16) 0.08 (6)
Wood and products of wood and cork 0.1749 (3)
Pulp, paper, paper products, 0.064 (6) 0.152 (18) 0.213 (5) 0.134 (2)
printing and publishing
Coke, refined petroleum 0.186 (6) 0.266 (11) 0.181 (4) 0.095 (6)
products and nuclear fuel
Chemicals excluding pharmaceuticals 0.038 (5) 0.217 (28) 0.076 (5) 0.194 (1)
Pharmaceuticals 0.083 (3) 0.22 (2) 0.118 (2)
Rubber and plastics products 0.045 (1) 0.192 (7) 0.337 (1)
Other nonmetallic mineral products
Iron and steel
Nonferrous metals 0.09 (1)
Fabricated metal products, 0.032 (2) 0.249 (10)
except machinery and equipment
Machinery and equipment, nec 0.052 (7) 0.275 (23) 0.195 (10) 0.066 (1)
Office, accounting and computing machinery 0.014 (1) 0.07 (2) 0.117 (1)
Electrical machinery and apparatus, nec 0.062 (2) 0.168 (5) 0.073 (1)
Radio, television and communication equipment 0.11 (6) 0.126 (5) 0.179 (3) 0.23 (1)
Medical, precision and optical instruments, 0.0971 (3) 0.138 (8) 0.355 (2)
watches and clocks
Motor vehicles, trailers and semi-trailers 0.117 (8) 0.354 (1) 0.112 (2) 0.204 (1)
Building and repairing of ships and boats 0.069 (1)
Aircraft and spacecraft 0.069 (1)
Railroad equipment 0.041 (1)
and transport equipment nec
Manufacturing nec 0.087 (14) 0.188 (50) 0.181 (8) 0.127 (6)
Electricity, gas and water supply 0.09 (4) 0.048 (2) 0.108 (1)

Based on the above classification, we constructed a measure of sectoral trade in-

tensity as follows:
 

 (xsk,t + m sk,t ) 

2003 
 
k
= j
τs j ≡ ,

t=1991 
ys,t 

 

where τ sj is the average trade intensity in sector s of country j during the period
1991–2003, x jk,t and m jk,t denote real exports and imports (once converted in units
of country j’s currency) of sector s in year t from and toward country k, respectively
(with k
= j), and y s,t denotes real gross output in sector s in year t.
We are interested in the cross-sectional effect of trade intensity on the size of the
commonality ratio. We therefore estimated the following regression:

σs j = α + βτs j + εs j ,
 TOMMASO MONACELLI AND LUCA SALA : 115

TABLE 6
INTERNATIONAL COMMONALITY AND TRADE INTENSITY

σ sj = α + βτ sj + ε sj (N . obs. = 61)

α 
β R2

m.o.m. log changes 10.41 [6.99] 0.21 [3.02] 0.13

y.o.y. log changes 20.12 [6.35] 0.52 [3.46] 0.17

NOTE: t-statistics in square brackets.

where both σ sj and τ sj are expressed in percentage terms. The results are summarized
in Table 6.
Trade intensity turns out to be significant and exhibits a positive sign. Our estimates
indicate that a 1 percentage point increase in trade intensity leads to an increase in
the sectoral international commonality ratio (i.e., the average percentage of variance
explained by the international common factor in sector j in the time period considered)
of 0.2 percentage points in the case of m.o.m. log-change transformation, and of 0.5
percentage points in the case of y.o.y. log-change transformation. Overall we interpret
these results as lending support to the view that emphasizes the link, at the business
cycle frequency, between international commonality of (traded goods) inflation and
trade integration.

5. COMMON CURRENCY RESULTS

So far we have worked under the assumption that product inflation rates are ex-
pressed in local currency. Our main justification for not converting all data in common
currency so far is that our analysis is not concerned with the dynamics of product-level
real exchange rates. In other words, we are not interested in inspecting the (statistical
properties of the) deviations from the law of one price at the product-category level. 11
Our goal is rather to find a common international component in the rate of change
of product-category inflation rates, among possibly very different goods. 12 It is how-
ever interesting to investigate whether our results are sensitive to a common-currency
transformation: in particular, we wish to assess the role of nominal exchange rate
movements in affecting the degree of international commonality in product-category
inflation rates.
We express all data in U.S. dollars. Figure 5 displays the estimated value of the
international commonality ratio, σ ij , in the common-currency case. For the sake of

11. For an analysis of product-category real exchange rates, and of the determinants of the deviations
from the law of one price at that level of disaggregation, see Crucini, Telmer, and Zachariadis (2005) and
Crucini and Shintani (2006).
12. For an approach similar to ours, in which inflation rates are not converted in common currency, see
Ciccarelli and Mojon (2007) and Altissimo, Mojon, and Zaffaroni (2007).
116 : MONEY, CREDIT AND BANKING

US
0.9 GER
FRA
UK
0.8

0.7 mean 0.62

0.6

0.5

0.4

0.3

0.2

0.1

0
0 100 200 300 400 500 600 700 800 900

FIG. 5. International Commonality Ratio: Common-Currency Specification.

brevity we report results based on the m.o.m. transformation only (the picture is sim-
ilar in the case of y.o.y. log changes). The transformation to a common-currency has
dramatic implications: the average commonality ratio rises from about 0.15 in the
local-currency case (see Figure 2 above) to about 0.62 in the common-currency case.
The intuition is simple: in our sample, nominal exchange rates are significantly more
volatile than product-category inflation rates. 13 Hence, converting to a common cur-
rency leads, for some countries, to a large amplification of the international common
component. This is especially true if the bilateral exchange rates with the U.S. dollar of
any pair of countries follow a similar dynamic. Table 7 reports average commonality
ratios by country. Notice that the amplification effect is especially strong for France
and Germany, whose nominal exchange rates against the U.S. dollar have followed
similar dynamics during the span of our sample (with this feature of exchange rate
comovement strengthening in the transition towards the euro). Clearly, the amplifi-
cation effect does not apply to the U.S. data, for the impact of the nominal exchange
rate variations is nil in this case. As a result, the common-currency transformation
makes the U.S. inflation series substantially insular relative to the ones of the other
countries in the sample.

13. The standard deviations of the bilateral nominal exchange rates of Germany, France, and the United
Kingdom with the United States are, respectively 2.62%, 2.56%, and 2.29% in our sample. Those numbers
should be confronted with the standard deviations of product-category inflation rates reported in the first
column of Table 1.
 TOMMASO MONACELLI AND LUCA SALA : 117

TABLE 7
INTERNATIONAL COMMONALITY RATIO: COMMON CURRENCY

U.S. Germany France UK

m.o.m. log changes 0.04 0.92 0.91 0.41

y.o.y. log changes 0.09 0.94 0.95 0.35

NOTE: The international commonality ratio measures for each series π ij,t the percentage of variance explained by the common international
factor.

TABLE 8
INTERNATIONAL COMMONALITY AND TRADE INTENSITY: COMMON CURRENCY

σ sj = α + βτ sj + ε sj (N . obs. = 61)

α 
β R2

m.o.m. log changes 41.04 [5.75] 1.15 [3.40] 0.16

y.o.y. log changes 44.04 [5.91] 0.96 [2.70] 0.11

NOTE: t-statistics in square brackets.

Next we wish to assess whether the transformation to a common currency affects

our results on the relationship between international commonality and trade intensity.
Table 8 displays the results of our basic regression of the commonality ratio on the
average trade intensity in sector s of country j. Interestingly the results are confirmed:
trade intensity continues to have a strong and statistically significant effect on inter-
national commonality of product inflation rates. The only difference concerns the size
of the effect: under a common currency transformation the size of this effect (i.e., the
estimated β coefficient) rises substantially relative to the case in which the data are
expressed in local currency.

6. FREQUENCY DOMAIN: MORE COMMONALITY AT LOW FREQUENCY

We have established that international factors are a potentially important determi-

nant of common variations in consumer price inflation rates. Yet is this a high or low
frequency phenomenon? We explore this question by reporting results for model (1)
in the frequency domain.
Figure 6 displays the contribution, at any given frequency (measured on the hori-
zontal axis), of the first four dynamic principal components in explaining the spectrum
of the whole international panel composed of all countries considered simultaneously.
At this stage we are showing results based on the m.o.m. log-change transformation
only.
118 : MONEY, CREDIT AND BANKING

0.09

0.08

0.07

0.06
spectrum

0.05 1st principal component

2nd principal component
3d principal component
4th principal component
0.04

0.03

0.02

0.01

1 yr. 6 months
0
0 0.5 1 1.5 2 2.5 3 3.5
frequency

FIG. 6. Contribution of the First Four Dynamic Principal Components (dpc) to the Spectrum of the Entire International
Cross-Section at Any Given Frequency.

NOTES: The integral below each dpc represents the percentage of variance of the whole international panel explained by
the same dpc. Sample size as from Table 1. Data are in m.o.m. log changes.

The spectral densities of the dynamic principal components have been normalized
so that the integral of the spectrum corresponding to each principal component repre-
sents the percentage of variance of the panel explained by that component. The main
observation we can draw from Figure 6 is that most of the contribution in explaining
the variance, for any given principal component, is at low frequencies. We observe
that the first dynamic principal component explains most of the variance of the inter-
national panel for cycles of period longer than 1 year. It is interesting to point out that
this result holds true despite the m.o.m. log-change transformation tends to magnify
the importance of high frequency movements relative to the y.o.y. transformation.

7. CONCLUSIONS

We have estimated the contribution of international factors in driving the common

dynamics of price inflation rates of a large cross-section of CPI products in four OECD
countries: United States, Germany, France, and United Kingdom. We have concluded
that, on average, one international common factor explains between 15% and 30%
of the variance of consumer price inflation rates. Given the high level of disaggrega-
tion of our panel, our estimate is best viewed as a lower bound for the contribution
 TOMMASO MONACELLI AND LUCA SALA : 119

of international factors to inflation dynamics. We then systematically explored the

relationship between exposure to international shocks and sectoral trade intensity.
We found a positive and statistically significant relationship between commonality in
inflation (measured as the ratio of the variance of a price inflation series explained
by an international common factor to the raw variance of the same series) and trade
openness at the sectoral level. This relationship is particularly strong when inflation
rates are computed as y.o.y. log changes, and at least qualitatively, it is not affected
by the currency transformation adopted.
Our analysis lends itself to several extensions. First, our panel is restricted to only
four countries. This sample of countries may be suggestive of the likely importance of
international factors for the evolution of consumer prices, but is far from exhaustive.
Extending the cross-section to include the role of more countries, and especially from
emerging markets, is a task of first-order importance. This extension has costs, though,
for it may lead the size of the cross-section to grow considerably, thereby forcing to
sacrifice information on the level of disaggregation.
Second, our result that the degree of sectoral trade intensity seems relevant for
the role international factors is warranted further refinement. For instance, prices of
consumer goods that are in principle more tradable than services may still contain
a large nontraded component (e.g., distribution costs) (see, for instance, Burstein
et al. 2006). Assessing the role of international factors for the dynamics of goods
prices when such nontraded component is adequately accounted for, and exploring
its relationship with trade intensity, would be an interesting topic for future research.
One way to address this issue would be to collect sufficiently disaggregated data at
the producer price level, where the role of a range of nontraded factors is presumably
controlled for. If trade intensity is indeed a significant determinant of the international
exposure to shocks of inflation, we expect to find an even stronger relationship at the
producer than the retail level.
Third, our investigation on the role of international factors for inflation dynamics
remains nonstructural. This is a general feature of the recent literature on the interna-
tional dimension of inflation. Making progress on the interpretation of the underlying
economic forces that may have contributed to “internationalize inflation” is a first-
order priority for researchers interested in shaping the monetary policy debate on this
issue.

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