Inflation dynamics in Egypt: Structural determinants versus transitory Shocks

Abstract

This paper studies recent inflation dynamics in Egypt with the objective of assessing whether structural factors are behind the trend rise in inflation since 2003. Using an autoregressive distributed lag (ARDL) model, we uncover the role of two significant determinants of long-run inflation dynamics: excessive monetary growth, and a rise in the intensity of relative price variability. These two variables are shown to play a key role in explaining inflation developments over the period January 2000 to October 2018 after controlling for the impact of exchange rate devaluations, energy price liberalization, adverse supply-side shocks and movements in international commodity prices. While the latter group of variables was influential in triggering inflation waves over the short to medium term, our empirical results show that excessive monetary growth and increased variability in relative prices are the main drivers behind the trend rise in inflation. The paper also estimates an unrestricted vector autoregressive (VAR) model to further study the direction of causality between inflation and relative price variability. Results from the forecast error variance decomposition show that relative price variability accounts for the largest proportion of the variance decomposition for inflation, further confirming its central role in driving inflation dynamics. In addition, the impulse response functions also indicate the strong response of inflation to positive RPV shocks, while inflation appears to have an insignificant effect on RPV. Furthermore, our ARDL model demonstrates superior predictive ability when its out-of-sample forecast performance is compared with benchmark models. The policy implications of our findings point to the immediate need to curb excess money growth in the economy, and also the pertinence of treating the issue of price liberalization using a holistic long-run plan as opposed to the historically-adopted piecemeal approach.

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