Inlation in Hong Kong, SAR- In Search of a Transmission Mechanism

Inflation in a country with a currency board is usually believed to be highly dependent on external factors. Important questions for understanding the dynamics of inflation are (i) how best to measure these factors and (ii) how to model the transmission mechanism. This paper brings evidence to both questions. First, the paper shows that using CPI-based measures of foreign inflation does not adequately capture external influences on inflation in Hong Kong. Second, the paper shows that import prices and wages have a significant causal role. Together these conclusions suggest that Hong Kong¡¦s price dynamics can be modeled by a Phillips Curve in which marginal cost of production plays an important role. When we estimate a New Phillips curve model for Hong Kong, a significant forward-looking component to expectations is identified. In addition, we find that prices are relatively flexible in HK, with adjustments taking place almost twice as fast as in the United States. Finally import prices and property rental rates appear to be important components of marginal cost of production alongside wages. More traditional versions of the Phillips curve also fit the data quite well. Even in this traditional specification, however, measures based on changes in production cost outperform measures of excess demand as forcing variables.