Posted by: mulrickillion | December 18, 2011

Inflation Differentials in the GCC: Does the Oil Cycle Matter?

By Kamiar Mohaddes and Oral Williams

International Monetary Fund (IMF), Working Paper No. 11/294, December 2011 —

Summary: This paper uses a pairwise approach to investigate the main factors that have been driving inflation differentials in the Gulf Cooperation Council (GCC) region for the past two decades. The results suggest that inflation differentials in the GCC are largely influenced by the oil cycle, mainly through the credit and fiscal channels. This implies that closer coordination of fiscal policies will be key for facilitating the closer integration of the GCC economies and ahead of the move to a monetary union. The results also indicate that after controlling for cyclical factors, convergence increased even during the recent oil boom.

[An excerpt from the Working Paper reads]:

Although inflation differentials between the Gulf Cooperation Council (GCC) countries have persisted for some time, they seemed to have tightened toward the end of the 1990’s (Figures 1 and 2).1 However, following the 2003 upsurge in oil prices, inflation rates in the region began to diverge once more, as fiscal policy became increasingly expansionary and contributed to rising domestic demand (Figure 3). The increase in inflation differentials is surprising given the increased integration of these economies over the last three decades, a peg to a common currency (the U.S. dollar, or in Kuwait a basket that closely follows the U.S. dollar), flexible labor markets, and open capital accounts. Moreover, minimizing inflation differentials across the GCC is a key convergence criterion in the planned GCC monetary union. In this context, it is important to understand the factors influencing inflation differentials to facilitate the closer integration of the GCC economies and ahead of a move to a monetary union.

This paper investigates the factors driving inflation differentials across the GCC countries, including the role of macroeconomic policy, structural factors and the role of inertia in influencing the speed of convergence over time. To this end, we follow Pesaran et al. (2009) and develop an econometric model based on pairwise inflation differentials in a panel setting. Our approach differs from the specifications generally considered in the literature, where the focus is on the inflation differential between each country in the monetary union and the union’s average. One important feature of our approach is that it relaxes the assumption of a uniform response by all countries in the monetary union to macroeconomic shocks.

The results indicate that after controlling for cyclical factors, convergence has increased even during the recent oil boom. We find that inflation dynamics in the GCC are largely driven by the oil cycle, mainly through the credit and fiscal channels. Given this result, for the proposed monetary union to be successful, closer coordination of fiscal policies will be critical. Avoiding procyclical fiscal policy is a key challenge for the proposed monetary union and will require a strong medium-term framework to reduce the risk of overheating of the economy and avoid increased divergence of inflation rates. . . .

>>Read the full Working Paper here (wp11294.pdf).

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