Nonlinear Input Cost Pass-through to Consumer Prices: A Threshold Approach

This paper examines a possible nonlinearity in the pass-through to CPI inflation of increases in firms' input costs. Using Japanese data, the paper empirically investigates whether the degree of the pass-through rises when increases in costs exceed a certain threshold. Three main empirical results are obtained. First, there is a statistically significant nonlinearity in that the pass-through to CPI inflation of increases in producer prices, exchange rates, and wages rises once the increase in each of these variables exceeds a certain threshold. Second, our nonlinear model is superior to the linear model used in previous studies in terms of in-sample model fit and out-of-sample forecasting performance, suggesting that the linear model underestimates the degree of the pass-through of an input-cost increase that exceeds the threshold while overestimating that of a smaller input-cost increase. Third, the estimated impact of the nonlinear pass-through of increases in producer prices and exchange rates on CPI inflation is often transitory, whereas that of wage growth tends to be persistent due to the observed higher inertia in wage growth. These results suggest that whether a nonlinearity will arise in the pass-through of wage growth is one of the most important issues for future developments in CPI inflation.