What Does Foreign Inflation Tell Us About Future Domestic Inflation? Evidence from the G7 Countries

This paper evaluates the ability of foreign inflation to predict future domestic inflation. A simple model is proposed which obeys an error correction representation. The error correction term has significant predictive ability over future domestic inflation in all G7 countries and in horizons that vary from one- to thirty six-months. Out-of-sample comparisons reveal that the proposed model outperforms in a significant way, univariate models at the one- and two-month horizons. This is a useful result for policymakers, since interest rate models, for instance, are unable to provide useful information about future domestic inflation in horizons shorter than six months