Global Factors Driving Inflation and Monetary Policy: A Global VAR Assessment

This paper examines the nexus between inflation and central bank interest rate policies in inflation-targeting countries. First, it looks at the role of inflation among other factors affecting monetary policy. Second, it looks at the drivers of inflation alone. Thereby, the role of international spillovers from other countries is explicitly regarded as well, with the aim of assessing the extent to which inflation is driven by other countries’ inflation or monetary policy is influenced by other economies. The empirical study covers advanced countries and emerging market economies for the period 1995 - 2016 and uses Bayesian global vector autoregression to model external linkages and to account for variable uncertainty. This study finds that inflation plays an important role for monetary policy. More importantly, central banks clearly consider additional factors and notably other countries’ key indicators when setting interest rates. Inflation in turn is determined by both internal and external factors like the exchange rate and other countries’ inflation. These findings are much more comprehensive than previous literature and demonstrate that central banks consider a multitude of domestic and global factors.