Does domestic output gap matter for inflation in a small open economy?

The experience of the last decades revealed the weakening of the relationship between inflation and a domestic output gap in many small open economies. However we may expect that there is still a substantial share of inflation basket which is sensitive to domestic economic activity, in particular non-tradable goods and market services. It would imply that even in a small open economy the central bank may affect inflation via the output gap to some extent. To answer this question we wanted to investigate which categories of goods and services in the Polish economy are sensitive to the domestic output gap. Additionally we investigated the exchange rate pass through at COICOP group levels. The issue is relevant for the central bank, which conducts the monetary policy in the small open economy. We conducted a disaggregated analysis using price indices at the COICOP 4-digit level. We specified a variant of small open economy Phillips curve for individual price indices. To increase the robustness of the results we used different measures of the output gap. We found that more than 50 per cent of the categories react to output gap. The results are robust to a choice of output gap measure and according to our expectations the categories which are mostly linked to the output gap are services but also non-durable goods. We found that only small share of durable and semi-durable goods react to domestic economic activity, which can be explained to some extent by globalization process as argued by Borio and Fillardo [2007]. Prices of several goods from these categories were in a downward trend during the last decade unrelated to the cyclical position of the Polish economy. We identified also the groups of goods and services, for which the price elasticity of domestic demand was rather weak and which do not react to the output gap as well. Investigating the exchange rate pass through at COICOP group levels we found that more than one third of the price indices in the Polish economy respond to exchange rate movements and/or foreign inflation. The impact of exchange rate is the most substantial for durable and semi-durable goods which are to large extent perceived as tradable goods. Finally we aggregated the price indices for goods sensitive to domestic economic activity and formed an index which, taking into account the substantial uncertainty and lags in calculating output gap, may be used as an alternative measure of domestic inflationary pressure.