Inflation is a global problem

Federal Reserve Bank economists in Chicago studied closely the inflation phenomena globally and found some interesting results. Inflation is a global issue. While this does not seem likely a surprising result, the size of the common variance is higher than what many would expect. Additionally, because the common factor is so high, it is hard to isolate the relative inflation effects across countries.

Approximately, 70% of the variance of inflation is associated with a common factor. We are already seeing this common effect with the kind of food and oil shocks around the world. Singular global shocks will cause the high common variance. Additionally, if the monetary policy response around the world i similar there will be a high common factor. If there is a loose monetary policy in response to shock there will be more common inflation.

Yet, there is a mean reverting or error correction component to the inflation rate so that inflation in individual countries will revert back to the longer–term global rate. Any inflation impact in a single country will not be sustainable relative to the rest of the globe. This mean-reversion is affected by the level of openness around the globe and the fact that exchange rates and capital will respond to these differences. The pattern of behavior is very much the same with a real shock in the short run followed by monetary behavior which will drive the inflation action in the longer-run. Inflation shocks and monetary developments are closely intertwined and really cannot be separated.

You cannot separate the inflation in one country from what is happening in the global economy. We can also say that high inflation countries will not sustain this behavior and being a buyer of high real and nominal rates versus a seller of low rates makes sense. This means that carry trades can still exit but the risks are different. Clipping coupons and picking up yield have to be substituted for duration plays where the expectation is that yields will fall or rise with inflation reversion.