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Relative Goods' Prices, Pure Inflation, and the Phillips Correlation

  • Ricardo Reis
  • Mark W. Watson

This paper uses a dynamic factor model for the quarterly changes in consumption goods' prices to separate them into three independent components: idiosyncratic relative-price changes, a low-dimensional index of aggregate relative-price changes, and an index of equiproportional changes in all inflation rates, that we label "pure" inflation. The paper estimates the model on U.S. data since 1959, and it presents a simple structural model that relates the three components of price changes to fundamental economic shocks. We use the estimates of the pure inflation and aggregate relative-price components to answer two questions. First, what share of the variability of inflation is associated with each component, and how are they related to conventional measures of monetary policy and relative-price shocks? We find that pure inflation accounts for 15-20% of the variability in inflation while our aggregate relative-price index accounts most of the rest. Conventional measures of relative prices are strongly but far from perfectly correlated with our relative-price index; pure inflation is only weakly correlated with money growth rates, but more strongly correlated with nominal interest rates. Second, what drives the Phillips correlation between inflation and measures of real activity? We find that the Phillips correlation essentially disappears once we control for goods' relative-price changes. This supports modern theories of inflation dynamics based on price rigidities and many consumption goods.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13615.

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Date of creation: Nov 2007
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Publication status: published as Ricardo Reis & Mark W. Watson, 2010. "Relative Goods' Prices, Pure Inflation, and the Phillips Correlation," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(3), pages 128-57, July.
Handle: RePEc:nbr:nberwo:13615
Note: EFG ME
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  1. Riccardo Cristadoro & Mario Forni & Lucrezia Reichlin & Giovanni Veronese, 2001. "A core inflation index for the euro area," Temi di discussione (Economic working papers) 435, Bank of Italy, Economic Research and International Relations Area.
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  14. Bai, Jushan & Ng, Serena, 2007. "Determining the Number of Primitive Shocks in Factor Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 25, pages 52-60, January.
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  16. Milton Friedman & Anna J. Schwartz, 1963. "A Monetary History of the United States, 1867-1960," NBER Books, National Bureau of Economic Research, Inc, number frie63-1, October.
  17. Jushan Bai, 2003. "Inferential Theory for Factor Models of Large Dimensions," Econometrica, Econometric Society, vol. 71(1), pages 135-171, January.
  18. Jushan Bai & Serena Ng, 2006. "Confidence Intervals for Diffusion Index Forecasts and Inference for Factor-Augmented Regressions," Econometrica, Econometric Society, vol. 74(4), pages 1133-1150, 07.
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