Disinflation and inflation convergence: evidence and lessons for Latin America
One geographic area that has long struggled to end high and chronic inflation is Latin America. Latin American countries have endured bouts of high inflation and hyperinflation in the recent past and some of them (mainly Venezuela and Argentina) are currently grappling with this scourge again. For the remaining countries, on a general basis inflation has come down from high numbers in the 70s, 80s and 90s to more moderate rates in the present decade. It is worth mentioning that, in addition to opening themselves up to trade, countries like Mexico, Chile, Peru, Colombia and Uruguay are known to have been quite successful in bringing to birth a full-fledged inflation-targeting regime.Footnote 7 The inflation rates after the implementation of the new framework plummeted in all these economies.Footnote 8 Additionally, to be sustainable, this monetary arrangement calls for the conduct of a more rigorous fiscal policy which may have also played some role in helping drive inflation down over time.Footnote 9 It is important to mention that the evidence mostly points to the existence of a positive relation between the interplay of globalization and monetary policy, via the incentives that the former raises for central banks to behave prudently, and disinflation.
To our knowledge, the literature on the effects of the interaction of the aforementioned factors on inflation convergence within countries is fairly scant, especially in Latin America. Intuitively, a country’s regions, subject to the same monetary policy and roughly similar structural reforms and fiscal policies, should in principle experience long-run inflation convergence (Yilmazkuday 2013). Moreover, if, as a consequence of a further step taken toward a deeper economic and monetary integration, some of these joint policies are carried out at a supranational level, while others are influenced or restricted by common rules set at the same level, a stronger sub-national inflation convergence is likely to occur, at least throughout the initial stages of the process.
From a policy-oriented perspective, we view this analysis as relevant since non-negligible differences in real interest rates could arise within the country did regional inflation rates differ from each other, due for instance to distinct cyclical positions across these regions’ economies, thereby perpetuating diverging economic performances at regional level. Besides, persistent differences in inflation might reflect permanent structural rigidities that prevent the regions hardest hit by shocks from adjusting swiftly.
Let us now pick two countries, Mexico and Peru, among the “globalizers” we just chose because of data and empirical evidence availability. In the case of the former, to the best of our knowledge, only studies on regional (relative) price convergence can be found. Sonora (2005) tests whether the PPP hypothesis holds across Mexico’s main cities. His results show that there is relative price convergence in the long run. Furthermore, he also suggests that prices are relatively flexible, which runs counter to the slower long-run price convergence found for US and Canadian data. Gómez-Aguirre and Rodríguez-Chávez (2013a, b) also examine price convergence across the main Mexican cities by employing panel data unit root tests. Their findings in both papers coincide with Sonora’s: absolute price parity holds in the long run. As far as inflation convergence is concerned, a quick inspection of Mexican provincial inflation rate data (Instituto Nacional de Estadística y Geografía) provides a clue as to whether there has been regional/provincial inflation convergence over time. A simple sigma-convergence analysis leads us to think this has been the case. Mexico is a NAFTA member and is therefore relatively integrated by commercial and financial ties with the US and Canada, and with the rest of the world as well. This relevant economic integration, coupled with sound economic policies, in part due to the necessary consistency with the status of being a more open economy, may have contributed to this regional/local inflation convergence coming about over time.
On the Peruvian economy, Winkelried and Gutiérrez (2012) show that the central bank of Peru, by having targeted Lima’s inflation, has been in fact influencing the economy-wide inflation,Footnote 10 which in the end constitutes an indication that regional inflation rates have converged over time. By means of a multivariate dynamic model of inflation comprising the main nine regions in the country, they conclude that the relative PPP holds among pairs of regional inflations. Again, Peru is an economy whose recent progress on the macroeconomic and institutional front has been remarkable. This virtuous cycle, in a way sparked by these aforementioned good policies,Footnote 11 has materialized itself in considerable economic growth rates and low inflation.Footnote 12 A steady convergence in regional inflation is an expected outcome given the policies put in place from the 90s onwards.
As may be seen, the Spanish case that we choose to analyze in this article can be generalized to other open economies, such as several in Latin America, to the extent that these latter economies share certain characteristics with the Spanish economy (degree of openness, central bank behavior, fiscal policy stance, etc.).
Disinflation and inflation convergence within a European context
After the view of the processes of disinflation and convergence in inflation in Latin America, we are going to concentrate now on the Spanish case, logically placed within the euro area context. The process of Spanish disinflation in the past decades is well-known, and it has been widely studied using mainly the SVAR methodology—see the survey by Gómez and Usabiaga (2001).
As regards convergence, there exist several strands in the literature covering price level convergence, inflation convergence and inflation differentials. Although logically those literatures are closely related, each one of those research lines has some economic and econometric specific features. On the inflation rates and their convergence, main topic of our paper, there are more country-based case studies than region-based ones. For instance, there is a lot of literature on this topic for Western European countries. One can also find abundant literature on the euro area countries’ inflation differentials—see de Haan (2010) for a survey as well as several ECB publications.
Although with slight caveats, related to the price indices, the time periods, or the countries considered, in general, for the euro area countries inflation convergence has been reported—see for instance Montuenga-Gómez (2002), Busetti et al. (2007) and Beck et al. (2009)—, mainly before the mid-90s. However, there still exist significant and persistent inflation differentials in the euro area (de Haan 2010), which even allow classifying countries under different categories or clusters—see for instance Montuenga-Gómez (2002) and Busetti et al. (2007).
Beck et al. (2009, p. 153), with the euro zone in mind, present the following classification of the potential underlying factors in inflation differentials—de Haan (2010) uses a roughly similar classification—: (1) differences between the actual positions of the economies within their business cycles, asymmetric shocks, and asymmetric effects of area-wide impulses such as monetary impulses, exchange rate movements or oil price changes. (2) The Balassa–Samuelson effect. (3) Inappropriate domestic policies or other unwarranted domestic developments such as misaligned fiscal policies, immoderate wage evolution, or other production input factor price developments. (4) Nominal wage and price rigidities. Beck et al. (2009) point out that the most worrisome factors are those of the two last types.
There is no clear consensus on the specific underlying sources of the inflation differentials among the euro area countries, although there may be a consensus about the fact that they are rooted on structural or institutional factors—see for instance Jaumotte and Morsy (2012) and Beck et al. (2009). In this respect, Jaumotte and Morsy (2012), for a panel of 10 euro area countries (period 1983–2007), conclude that in order to reduce the persistent inflation differentials the following labor elements have to be reformed: high employment protection, intermediate coordination of collective bargaining and high union density. In this line, de Haan (2010) highlights that most empirical research suggests that EMU has not spurred labor market reform. However, Beck et al. (2009) do not emphasize the labor factors for the regional euro area inflation differentials. In their opinion, those differentials are mainly accounted for by the costs of the non-wage input factors, the degree of competition and the economic structure of the regions. In other words, the observed long-run differences are chiefly caused by inefficiencies in factor markets and region-specific structural characteristics. They also remark that there is considerable heterogeneity in the economic structure of euro area regions such that even symmetric impulses—such as a monetary policy shock—can have heterogeneous effects.
From the analysis of the regional inflation rates of the euro area countries, Beck et al. (2009) state that national factors matter. Thus, the dispersion is higher among the regions of all the European countries analyzed (Austria, Finland, Germany, Italy, Norway and Spain) than among the regions of each country. In addition, differences are substantially more pronounced across regions than across country averages. These authors assert that the strong influence of the national factor very likely stems both from nationally conducted fiscal policy and nationally determined labor market institutions. In comparison to US regional inflation rates, the euro area regional rates show a slightly higher degree of dispersion and persistence. Using a factor model, Beck et al. (2009) find that the variation in euro area regional inflation rates is explained following these proportions: area-wide factors 50 %, national factors 32 %, regional elements 18 % (Spain: national factors 26.8 %, regional factors 24.6 %). They come to the conclusion that the Spanish differential in this respect can probably be explained by the relatively high degree of independence that Spanish regions enjoy.
Several works highlight that the monetary policy followed by EMU could have generated convergence effects also at regional level, due to its effect on expectations and other factors. For instance, Beck et al. (2009) state that the area-wide monetary policy can considerably contribute to regional inflation stabilization even though it cannot take regional developments into account when making its decisions. Apart from Beck et al. (2009), other works also report regional inflation convergence. For instance, Busetti et al. (2006) conduct an analysis of the price level and the inflation rate for the monthly series of the CPI in 19 Italian regional capitals over the 1970–2003 period, concluding that the convergence process is stronger for the inflation rate. Gozgor (2013) also observes convergence in Turkish regional inflation rates (period 2004–2011).
Yilmazkuday (2013) tackles a more disaggregated analysis of regional inflation, in the line of the works related to the Balassa–Samuelson literature. He works with ten main CPI groups for each region, distinguishing between groups concentrated on tradable and non-tradable components (period 1994–2004). In this study a break in Turkish inflation is captured in 2002, and in 2001 for the cross-sectional standard deviation of regional inflation rates. This author distinguishes between a pre-inflation targeting period and an inflation targeting period (which coincides with a flexible exchange rate) starting from January 2002. As in our study, Pesaran (2007a)’s methodology is used, among other techniques—Arestis et al. (2014) also use that technique, but applied to countries’ inflation. As acknowledged by Yilmazkuday (2013), the results of this work require further study since during the inflation targeting period the CPI groups with relatively tradable components have diverged from each other, while the non-tradable groups have converged to each other. Caraballo and Usabiaga (2009c) share some elements of the disaggregated study of Yilmazkuday (2013) in their analysis of Spanish and Andalusian inflation. Finally, in the present study we can state that when we disaggregate provincial CPI-based inflation rates into province-level inflation rates of the 12 COICOP groups of goods and services over the 1994–2015 period, we are able to uncover some interesting patterns. With the exception of the Communications group involving mainly non-tradables, all the other groups of goods and services appear to exhibit a high degree of convergence among pairs of inflation rates across provinces. This indicates that convergence in provincial inflation rates is widespread across groups of goods and services, irrespective of the tradables/non-tradables distinction.
It is well accepted that the Balassa–Samuelson effect fails to account for the euro area inflation dynamics—see ECB (2005), Rogers (2007) and Beck et al. (2009). The Spanish economy is not an exception in this regard, maybe because some of its assumptions do not hold in that economy; for instance features like a rather centralized wage determination, a low labor mobility, etc. (Jimeno and Bentolila 1998), run counter to its central assumptions. Juselius and Ordóñez (2009) point out that the potential Balassa–Samuelson effect has more influence over the high unemployment than over prices. Rabanal (2009) concludes that the Balassa–Samuelson effect does not appear to be an important driver of the inflation differential Spain-EMU during the EMU period, although a gap in labor productivity between tradable and non-tradable sectors can be noted. In addition, Alberola and Marqués (2001) reject the Balassa–Samuelson hypothesis at Spanish regional level. Finally, in Beck et al. (2009) this theory is not supported for the Spanish regions. To sum up, there is overwhelming evidence against the relevance and explanatory power of that hypothesis for the Spanish economy. Our results do not support the Balassa–Samuelson hypothesis since there is not a significantly higher degree of convergence among pairs of provincial inflation rates for tradables, relative to non-tradables (of course bearing in mind the exception of the Communications sector). Likewise, our multivariate regression analysis provides evidence of a significantly negative impact of real GVA per capita growth on the inflation rate, which runs counter to the positive effect that would be predicted according to the Balassa–Samuelson hypothesis.