Inflation Convergence over Time: Sector-Level Evidence within Europe
One sentence summary: Average half-life of inflation differentials across European countries has decreased from about 15 months to about 8 months within the last two decades.
The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at International Finance.
Working paper version is available here.
Abstract
This paper investigates inflation convergence among European countries by using sector-level data for the period between 1997:M1 and 2019:M12. Panel unit root tests at the country-sector level are conducted by using moving windows, which is useful to analyze changes in inflation convergence and the corresponding speed of convergence over time. The results suggest evidence for inflation convergence for the majority of sectors within Europe, although disruptions have been experienced by certain countries, especially during the 2008 financial crisis. Regarding the speed of inflation convergence, the average half-life across European countries has decreased from about 15 months to about 8 months during the sample period. Important sector-level implications follow for European Union (EU) candidate countries and non-euro EU member countries regarding the Maastricht Treaty.
Non-technical Summary
Inflation convergence is one of the important criteria in the Maastricht Treaty to ensure price stability and integration within the European Union (EU). This criterion not only requires member countries to have a high degree of price stability but also calls for a price performance that is sustainable for the adoption and continuous circulation of euro. Accordingly, when candidate countries are considered for EU membership or the Euro Area (EA), part of the evaluation is achieved through inflation convergence. Moreover, even when a country is an EU member or within EA, its performance of price stability is evaluated over time for sustainability. It is implied that an investigation of inflation convergence within Europe over time is essential for the price stability and continuous integration of EU.
This paper achieves such a time-varying investigation for inflation convergence among European countries. The formal analysis is conducted by using four-digit sector-level inflation data from 34 countries covering the monthly period between 1997:M1-2019:M12, where five year (i.e., sixty months) moving windows are considered to have a time-varying investigation. Panel unit root tests are used to investigate the convergence of inflation rates at the country-sector level. In particular, country-sector specific panel estimations are achieved by comparing sector-level inflation rates of each country with those of other countries within Europe; i.e., the cross-sectional dimension of the panel unit root tests consist of countries at the sector level.
Having a sector-level investigation is essential to avoid any aggregation bias. This type of an investigation is also useful to obtain sector-specific policy implications, especially for EU candidate countries and non-euro EU member countries, as such an investigation can reveal the sectors that are responsible for non-convergence (if any). Moreover, different from country-level analyses where evidence for only convergence versus non-convergence can be obtained, having a sector-level investigation results in obtaining information on the total expenditure share of sectors for which there is evidence for inflation convergence.
When there is evidence for convergence (if any) for a particular sector in a particular country, the corresponding speed of convergence is further investigated; this is convenient to observe how the speed of convergence has changed over time at the country-sector level. The corresponding results show that inflation convergence is achieved for all sectors in several countries for most of the sample period, although the total expenditure share of sectors experiencing convergence is as low as about 75% across countries.
Once estimations are achieved at the country-sector level, the corresponding results are further aggregated across sectors (of each country) to have country-specific results for inflation convergence. These country-specific results suggest that there is evidence for stability over time for most countries except for certain time periods that mostly coincide with the 2008 financial crisis. In particular, countries such as Bulgaria, Estonia, France, Ireland, Iceland, Lithuania, Latvia and United Kingdom have experienced disruptions in their sector-level inflation convergence processes during the 2008 financial crisis, whereas countries such as Switzerland, Hungary, Italy, Poland, Slovakia and especially Turkey have experienced disruptions in their sector-level inflation convergence processes starting from around 2015. Regarding the speed of convergence, the average half life across countries has decreased from about 15 months between 1997:M1-2001:M12 to about 8 months between 2015:M1-2019:M12.
Sector-level half-life estimates for the median country suggest that before the official circulation of the euro (i.e., between 1997:M1 and 2001:M12), half-life estimates have an average (across sectors) of about 17 months, with a range between 10 months (for "food and non-alcoholic beverages") and 26 months (for "restaurants and accommodation services"). By the latest period of 2015:M1-2019:M12, the average half-life estimate (across sectors) have reduced to about 11 months, with a range between 5 months (for "clothing and footwear") and 35 months (for "restaurants and accommodation services").
It is implied that especially "restaurants and accommodation services" is responsible for not having any further reductions in half-life estimates over time; as indicated in earlier studies, this can be fixed by having more labor mobility across countries, product diversification and trade openness.
The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at International Finance.
Working paper version is available here.