Price-setting Behavior and Inflation Dynamics in SEACEN Member Economies and Their Implications for Inflation

Over the past few years, Asian economies exhibited high growth and relatively low inflation rates. It is often argued that the process of inflation determination changed towards a more benign trade-off between economic slack and inflationary pressure. Factors such as global integration into goods and capital markets, the adoption of formal inflation targeting and changes in structural determinants of inflation such as oil and food prices, to name just a few candidates, potentially change the nature of inflation dynamics in small open economies. This collaborative research project on “Price-setting Behavior and Inflation Dynamics in SEACEN Member Economies and their Implications for Inflation†studies the changing nature of the inflation process in SEACEN economies from different perspectives and draws policy conclusions. We obtain three key findings: 1. Global as opposed to local determinants of inflation are increasingly important. Global shocks such as oil price shocks and global demand shocks explain a large share of the variation in inflation. Global determinants also change the slope of the Phillips curve. 2. The persistence of the inflation process changes over time, which in turn affects the time needed for inflation to return to the mean following a shock. Reforms in the institutional design of monetary policy such as the adoption of inflation targeting change the nature of inflation persistence. 3. The pass-through of energy prices and oil price, for example, to headline inflation is time-varying and country-specific. Overall, our results suggest that monetary policy in small open economies, which are well integrated into global markets for goods, services and capital, should take these structural changes into account. A policy framework based on an inflation target and a flexible exchange rate is well suited to cope with the changing inflation process.