International factors broadly explain postpandemic inflation

Since the pandemic began in early 2020, core inflation (excluding food and energy) has increased across countries worldwide. The trend contrasts with the nearly decade-long post-Global Financial Crisis (GFC) period during the 2010s, where such coordinated movement wasn’t as apparent.

The recent co-movement implies that inflation in many countries, including the U.S., can be explained in part by global and regional factors, suggesting policymakers may want to consider global events and pressures when addressing both the rise in inflation and the current decline in inflation pressures.

Path of inflation similar among nations since pandemic’s start

U.S. core Consumer Price Index (CPI) inflation remained elevated at 3.3 percent year over year in September 2024. U.S. inflation has exceeded the Federal Reserve’s target of 2 percent since February 2021. Accordingly, the Federal Open Market Committee (FOMC) raised the target policy rate 525 basis points (5.25 percentage points) between March 2021 and August 2023.

As inflation pressures subsided, the FOMC changed directions on Sept. 18, 2024, cutting the federal funds rate by 50 basis points, the first reduction in more than four years.

These trends are not unique to the United States. Inflation has been persistently high around the world during the pandemic recovery, causing virtually all central banks to impose restrictive monetary policy. Similarly, policy easing has occurred across many countries in recent months.

Inflation worldwide, though reaching relatively high levels during the pandemic, had been low and stable in the decade after the GFC, particularly in advanced economies. However, the co-movement of inflation across some of the world’s largest economies became clear with the pandemic (Chart 1).

Often, inflation is viewed as largely domestically determined—typically with central bank policy being paramount. Why, then, might inflation trend similarly across countries?

First, countries may face similar global shocks, such as oil-price shocks or common demand shocks that drive inflation everywhere. Second, countries may pursue similar monetary policy. For example, many countries have pursued inflation targeting in the last three decades, which in advanced economies converged on a target of around 2 percent. Third, globalization and the resulting integrated supply chains can amplify price shocks. Pandemic-related supply-chain disruptions, the blockage of the Suez Canal and instability in the Gulf of Aden and the Red Sea are examples.

How to model and measure global inflation

We extract dynamic latent factors from our data, which are unobserved time series describing the co-movements of inflation across countries. We estimate two factors per country—first, a global factor, which can be thought of as an index of global inflation, and a regional factor that explains region-specific inflation movements not captured in global trends. A factor model compared with a simple average allows the model to determine what weights a country gets when constructing an index of global inflation. A simple average would assign an equal weight to all countries.

Using the factors, we decompose the variance in each country’s inflation time series into global, region and country-specific (idiosyncratic) components, which reveal the extent to which the factors can explain a country’s inflation. The results we discuss below come from our ongoing research. Economists Ayhan Kose, Christopher Otrok and Charles Whiteman originally outlined the Bayesian methodology used to estimate this model. (Bayesian statistics treat model parameters as random variables.)

Narratively, the global factor remains low and relatively stable from 2010 until the pandemic, temporarily dips at the start of the pandemic and takes off from there (Chart 2).

This is consistent with the inflation time series in Chart 1. The region factors capture movements in the time series of the respective countries beyond what the global factor captures. The region factors are clustered with the global factor until the pandemic—all including modest amounts of noise.

Once the pandemic begins, the global factor increases dramatically, indicating global mechanisms of inflation were highly inflationary in the postpandemic era. Meanwhile, regional mechanisms were more muted, except in North America, where inflation increased a bit sooner than in the rest of the world.

A global factor can explain domestic inflation

We quantify how well the global and region factors explain domestic inflation using variance decompositions. We fit our factor models using headline and core inflation separately, which sheds light on how volatile goods (food and energy) are sensitive to international factors. Though the dynamic factors are estimated over the entire sample, we additionally estimate the model covering the prepandemic (January 2010 to February 2020) and pandemic (March 2020 to July 2024) subperiods.

This method reveals that the global factor explains substantially more variance in a country’s headline inflation time series, on average, across our entire sample during the pandemic period (74.5 percent) relative to the prepandemic period (40.2 percent).

The trend holds for core inflation as well, though the levels of variance explained are lower. For core inflation, the global factor explains just 6.9 percent of variance in inflation during the prepandemic period, which jumps to 72.2 percent during the pandemic. In fact, the prepandemic level of variance explained by the core inflation global factor may indicate that the global factor was almost nonexistent.

The U.S. provided no exception. For headline inflation, the global factor explains 60.7 percent of inflation variance during the prepandemic period and 81.3 percent during the pandemic. The U.S. also experienced this increasing trend for core inflation—jumping from just 1.2 percent of inflation variance explained by the global factor to 43.7 percent during the pandemic period (Chart 3).

In Mexico, we observe that the global factor explains an even more pronounced increase in the variance between the sample periods. For headline inflation, the percentage increased from just 4.8 percent to 78.9 percent. However, the difference across periods for core inflation is much smaller.

Region factors add context but are less important

The region factors represent commonality in inflation across the region not accounted for by the global factor. Among the regional factors, the differences between the prepandemic and postpandemic periods is mixed. For some regions, the variance explained by the region factor decreases, while for others it increases with varying results for headline and core inflation as well (Chart 4).

For the U.S. and Mexico, however, there are still increases in variance between the prepandemic and postpandemic eras explained by the core North America factor, though there is a slight decrease in variance explained by the headline North America factor for the U.S.

Changes in variance explained by the continental Europe factor tell an interesting story. For headline inflation, the variance explained by the continental Europe factor increases from 8.4 percent to 11.5 percent. However, for core inflation, it decreases from 18.6 percent to 2.0 percent between the two periods. Since the only difference between headline and core inflation is the inclusion of food and energy prices, it appears there were sizeable Continental Europe-specific movements in food and energy prices. An obvious explanation is the Russia–Ukraine war; Russia is a large energy provider to the rest of Europe, while Ukraine grows grains supplied to the continent.

The decreases we observe in variance explained by the region factors are likely due to substitution in variance explained from region to global factors. Each time there is a decrease in the variance explained by the region factor, it is of substantially smaller magnitude than the corresponding increase in variance explained by the global factor. This trend indicates that non-country-specific factors that help explain inflation have become more global. Taking the results for variance explained by the two factors together, country-specific (or idiosyncratic) factors have become less important for explaining inflation in the postpandemic era.

Why might global and region factors be important?

By regressing the variance decomposed by global and region factors on various indicators of economic structure, we can attempt to explain variance differences explained across countries.

We find that a country’s openness (the ratio of international trade to GDP) may be one of the factors explaining the variance decomposed for both headline and core inflation. For headline inflation, the government spending share of GDP and overall inflation volatility are also important. Despite this evidence, more research is needed to understand what causally affects a country’s sensitivity to global inflation.

What the results mean for the U.S.

Despite the elevated importance of non-country-specific factors in the postpandemic era, these factors have long helped explain domestic inflation. Economists Christopher Neely and David Rapach have shown this to be the case from 1951 through the GFC.

Work has also been done to decompose the kinds of shocks that most influenced inflation through the pandemic. A recent paper attributed much of variance in inflation to oil price and aggregate demand shocks. Regardless of the drivers of global inflation or the nature of the transmission of global factors to domestic inflation, inflation has become a much more global phenomenon.

Still, Federal Reserve and U.S. policy, more generally, is capable of returning the U.S. to the 2 percent inflation target. However, policymakers may need to monitor international events and potential international sources of inflationary pressures more closely.

Persisting wars in Europe and the Middle East as well as shipping frictions in the Red Sea and Panama Canal are examples of such international tensions that can have noticeable tailwind effects on U.S. inflation. Likewise, it is possible that healing global supply chains have helped the U.S. bring inflation down.