Assessing inflation expectations as early and as precisely as possible for appropriate, proper and timely action has traditionally been a primary role of central banks worldwide. At the same time, the assessment itself has always been challenging for the monetary authorities since inflation expectations are not directly observable, requiring a need to turn to suitable indicators for assessment instead such as surveys, extractions from yield curves and inflation-linked bonds (Tomfort, 2011). Moreover, central banks have often pondered on the question of whether expectations follow predominantly a forward-looking or backward-looking behaviour of firms. This question is important ultimately for the optimal monetary policy stance, via a process of understanding the different sources of inflation persistence and the costs of disinflation mechanisms (Dorich, 2009).
The empirical evidence here has been mixed. Some studies find a predominantly forward-looking behaviour of firms (Sakurai, 2016; Meng, 2016; Hervino, 2015; Gali & Gertler, 1999) while others argue that the backward-looking behaviour is more prominent (Tomfort, 2011; Mukhtar & Yousaf, 2014). These studies span across many years, countries and regions but have largely ignored the case of the Pacific Island Countries (PICs)—small, vulnerable, open economies. This study, therefore, using the case of Solomon Islands, attempts to fill that gap in literature. With a population of around 652,858, the archipelago encompasses around 28,000 square kilometres of land area. It accommodates many scattered islands, with a total of 10 provincial centres including Honiara, the capital city. It is a country of multi-cultural and diverse ethnicity. Since gaining its independence in 1978, the Solomon Islands economy has made reasonable progress in certain areas of development, however it has struggled to provide basic and adequate infrastructure development for its people. Its geographically scattered islands is a major constraint for its planned developments and service delivery.
The study uses the Hybrid New Keynesian Phillips Curve (HNKPC) framework. The model is estimated using quarterly data for the period 2003-2017. The estimation is conducted using the standard Ordinary Least Squares, the General Method of Moments and the Fully Modified Ordinary Least Squares methods. The study finds that both backward-looking and forward-looking behaviour of firms matter for inflation. The results show that fuel prices, output gap and real effective exchange rate are important indicators of current inflation. Policy implications are discussed.
Vitarina H Takana and Angeline H. Bata’anisia Central Bank of Solomon Islands, Tarlok Singh, Jen Je Su and Parmendra Sharma, Griffith University.
This paper was presented at the December 2018 South Pacific Central Banks—Griffith University inaugural research conference in Suva. Key stakeholders attending the conference included Reserve Banks of Australia and New Zealand, ADB, World Bank, IMF/PFTAC and DFAT. The views and opinions expressed in this study are those of the authors and do not reflect those of the Central Bank of Solomon Islands or its Board.
The full working paper is available at https://www.griffith.edu.au/asia-institute/our-research/south-pacific-centre-central-banking/working-papers.