Globalisation, inflation and monetary policy: it's not all good news

Global factors "are becoming empirically more relevant for domestic inflation determination across a broad range of countries". That is the not-so-surprising conclusion of a new BIS working paper, Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation, by Claudio E. V. Borio and Andrew Filardo. The authors find declining sensitivity of inflation to domestic output gaps, and rising importance of global measures of economic slack.

The authors caution that their "conjecture" is "just preliminary", and that their "results rely critically on a specification that filters out the disinflationary trend from the data"; more research is needed. Nonetheless, if this "more globe-centric view of the inflation process" is correct, what would that mean for monetary policy? Globalisation might increase the risk of monetary policy errors, especially asset bubbles, while weakening central bankers control over real interest rates:

First, the growing importance of global factors would call for more intensive monitoring of external developments. ...Given the lags of monetary policy, it might be important for central banks to respond to developing trends before they show up at the borders and become embedded in price and wage setting behaviour. ...At the same time, measuring global slack conditions is likely to be a challenge. The well-known difficulty of measuring real-time domestic output gaps, and economic slack more generally, would be magnified in the case of their global counterparts.

Second, and more speculatively, one should guard against the risk of systematic errors in policy. If, for instance, the downward pressure on inflation resulting from globalisation was underestimated, the result might be a surprisingly subdued inflation rate alongside unusually low policy rates. This, in turn, might have a number of undesirable side-effects, such as the unwitting accommodation of the build-up of financial imbalances, notably “excessive” credit  and asset price increases that could raise material risks for the economy further down the road. Indeed, global economic developments in recent years bear a certain resemblance to this perspective. Conversely, failure to appreciate the build-up of global inflationary pressures could result in surprisingly strong inflation, with the risk that central banks might fall behind the curve.

Finally, and even more speculatively, questions could ultimately be raised about the very effectiveness of domestic monetary policy. To the extent that, in a proximate sense, domestic inflation became increasingly influenced by global capacity constraints, this could weaken the near-term efficacy of domestic monetary policy levers, because of their limited (ie domestic) reach. ...central banks might find it harder to control inflation in the short term or, at least, may need to adjust their instruments more vigorously. The power of policy could be complicated further by the implications of financial globalisation, which could be weakening the ability of central banks to influence domestic real interest  rates, especially longer-term rates, independently of global conditions.

Previous posts:
* HSBC: Measuring the global output gap 14 February 2006
* IMF: How has globalisation affected inflation? 14 April 2006
* What does globalisation mean for monetary policy? 10 October 2006

Comments

[steve]

all the more reason why targetting inflation with an interest rate when you are running a large trade deficit, or surplus, is inane.

[Arthur Eckart]

The Fed has gone one step further. It has responded to potential trends. Consequently, U.S. monetary policy has been too restrictive. The Fed is willing to accept slower domestic growth to offset, and perhaps preempt, the domestic effect of a potential foreign negative shock. The ultimate goal of the Fed is to raise domestic living standards at the optimal rate, which is more important than the domestic goal of sustainable output through price stability. Obviously, the Fed has been most successful in raising domestic living standards.

[Lafayette]

AE: It (the Fed) has responded to potential trends.

You mean, of course, deflating the dot.com bubble that burst in 2000 before it ruined the life savings of millions of shareholders.

Yeah, right ...

[Arthur Eckart]

Lafayette, it's more accurate to say the Fed responds to major potential trends that it has the power to influence. The only way the Fed could have stopped the tech bubble was to create a recession. Also, I disagree the "dot.com bubble" "ruined the life savings of millions of shareholders." It generated a great deal of wealth, and reflected successful Fed policies (similar to more recent "bubbles," in the bond market, stock market, commodities market, housing market, etc.). The stock market crash of 2000-02 was a correcting mechanism to keep future labor supply and demand in equilibrium, because everyone cannot retire early. Nonetheless, even at the bottom of the crash, Nasdaq was four times higher than the early-'90s (i.e. recession or market trough in 1990 or 1991 to recession or market trough in 2001 or 2002).

[Lafayette]

AE: Nonetheless, even at the bottom of the crash, Nasdaq was four times higher than the early-'90s

Said like a true clinician, seemingly logical and utterly irrelevant.

What kind of response is this above? The Nasdaq was also 10 times higher than in the early-80s. So what, it's irrelevant.

People lost money in the market and those who bought in the sharp rise in late 1990 just before the bust in early 2000 have waited seven years to recover. There were many who piled in at the last minute, because they foolishly thought the stock market printed money.

If you feel the Fed should have done nothing about equity asset pricing, then certainly you feel the Fed should nothing about the real estate bubble either.

Some people buzz down the highway of life in a Ferrari and others are left as road kill. Simple world, yours.

[Arthur Eckart]

Lafayette, your implication that Nasdaq rose from 300 in 1991 to 5,000 in 2000, fell to 1,100 in 2002, and then rose to 2,500 in 2007 generally made people poorer doesn't make sense. The data don't support your belief, including the fact that for every seller (of stock) there's a buyer. The Fed doesn't care about individual markets, except how they affect the general economy. Obviously, the Fed has an excellent track record of smoothing-out business cycles, to optimize growth. The Fed targets the general price level of goods & services rather than asset prices, which are residuals. Your "bubbles" haven't affected the general economy much. You should praise the Fed's wisdom, ability, and performance to raise domestic living standards.

[Lafayette]

AE: The data don't support your belief

The Nasdaq run-up that created moist of the bubble is shown in this http://en.wikipedia.org/wiki/Image:Nasdaq_Composite_dot-com_bubble.svg>graphic of the Nasdaq index.

Just before the end of 2000, the Nasdaq was behaving in a orderly fashion with somewhat higher than normal appreciation in prices. However between September and January, people unwittingly piled into the technology market, creating the spike.

At that time, the conventional wisdom from Wall Street was, “The market is long-term. Keep your position and inevitably you will make money”. Unfortunately, they did not count on a bubble that was financed by millions who were betting on a freak acceleration in equity pricing defying all logic in the market.

As the graphic shows, the inevitable nadir was reached three years later, in the latter half of 2003. Prices bottomed, but till then anyone who had bought after Spring of 1997, three years before lost his shirt if he sold then. Many had been selling all the way down, and most were those who had jumped onto the rocket-powered bandwagon in the latter half of 2003.

Anyone who purchased after mid-1999 is just about to recover their losses some eight years later.

Cooler heads would have dampened the frenzy by restraining the ability to buy stocks on credit. The real estate bubble in the US is based upon the same erroneous reasoning.

Back to our debate, about the Fed. If the Fed’s primary responsibility is to control inflation, why did it not intervene when equity assets were hyper-inflating in 2000? Or more recently in the realty asset inflation?

[Arthur Eckart]

Lafayette, the stock market is the sum of all stock investors. If the stock market rises 1,000%, then the average investor made 1,000% (excluding commissions, taxes, etc.). I've shown evidence before that it's unlikely a general housing bubble exists. Obviously, the Fed did control inflation. It lowered the Fed Funds Rate to 1% in the early-2000s, after 20-years of disinflation, to avoid a liquidity trap.

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