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April 24, 2007

Does Globalization Make Monetary Policy Harder?

According to the Financial Times, the answer is "maybe", but the message is a bit tricky.  On the one hand:

... Take the renewed worries about how energy costs might contribute to broader price pressures...

Such cost contagion is, of course, not enough to cause inflation expectations to rise. Rather, it broadly shows markets doing their job in reacting to changes in relative prices. Higher oil prices encourage the use of substitutes. They also shift demand to goods and services less affected by the shock. As long as monetary policy remains steady, the end-result would still be painful but not inflationary.

That is right on target, but:

... According to conventional wisdom, globalisation has been one of the chief reasons why the loose monetary policy of the past decade has not translated into swifter consumer price inflation. Cheap imports from India and China were said to have eroded the pricing power of, say, US companies at home.

That view always raised a few questions, such as how long any such damping effect might last. Intriguingly enough, rising oil prices may already have caused it to wane.

Since the "cheap import" phenomenon is just another variant of "changes in relative prices", the article's first observation is perfectly apt: "As long as monetary policy remains steady, the end-result would still be painful but not inflationary."  But the author of the article apparently has something a little more complicated in mind:

Recent research by two economists, Paul Bergin and Reuven Glick, suggests prices of a wide range of goods did indeed converge globally – until about 1997. Since then, prices have drifted apart again, perhaps owing to rising transport costs.

Here, more specifically, is what Bergin and Glick uncover:

This paper documents significant time-variation in the degree of global price convergence over the last two decades. In particular, there appears to be a general U-shaped pattern with price dispersion first falling and then rising in recent years, a pattern which is remarkably robust across country groupings and commodity groups... However, regression analysis indicates that this time-varying pattern coincides well with oil price fluctuations, which are clearly time-varying and have risen substantially since the late 1990s. As a result, this paper offers new evidence on the role of transportation costs in driving international price dispersion.

The implication seems to be that globalization -- increasingly open trade, more precisely -- has introduced patterns in observed prices that make it more difficult to disentangle relative price changes from trend inflation.  There does not yet appear to be much evidence of such a problem appearing in the behavior of long-term inflation expectations:




Nonetheless, it is worth thinking about the FT's suggestion that the types of influences identified by Bergin and Glick "could make monetary policy a lot trickier going forward."      

April 24, 2007 in Federal Reserve and Monetary Policy | Permalink


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Tonight I’m going to party like it’s 1999! According to the data I just downloaded, Q1 1999 was the last time (and the only other time since they’ve been keeping track) that the SPF 10-year median CPI inflation forecast went below 2.45%. (I’m not sure why that doesn’t show up in your chart.) As of Q1 2007 it’s 2.35%. Indeed that’s the first time it’s been out of the narrow range of 2.45% to 2.55%. If I were a technical analyst, I think I’d call that a downside breakout. No wonder the yield curve is inverted! (On the other hand, though, why are TIPS yields so low?)

Posted by: knzn | April 24, 2007 at 09:47 AM

"Indeed that’s the first time it’s been out of the narrow range of 2.45% to 2.55%." Just to clarify: I meant the first time since 1999. Clearly it was above that range most of the time prior to 1999.

Posted by: knzn | April 24, 2007 at 09:50 AM

I think the globalization impact on monetary policy has more to do with capital flows. Take for example Japan. It appears low interest rates in Japan has resulted in capital outflows without influencing consumer spending. Whether you are a monetarist or Keynesian, consumers have to spend more currency in order for prices to rise. If shifts in interest rates result in capital flows and not consumer activity, the ability to influence consumer prices is diminished.

Posted by: TDDG | April 24, 2007 at 10:31 AM

TIPs derived 10 year expectations look different - rising recently rather than falling.


Posted by: Mark Thoma | April 24, 2007 at 11:44 AM

As I mentioned in reply to Mark’s comment on my blog, I’m getting skeptical about what the TIPS data suggest. (I’ve always been skeptical about the adjustment, and I am getting more so looking at the latest chart.) There’s obviously a lot going on in the TIPS market that has to do with things other than the expected inflation rate, and the adjustment does not seem to be capturing much of that, if any. It’s not quite a needle in a haystack, but finding a 10 basis point shift in actual inflation expectations within the non-classical pincushion of the TIPS market could be difficult. One issue that I think is relevant for the latest data is that the uncertainty surrounding inflation has probably risen. That would imply a rising risk premium, which might offset a change in the expectation.

Posted by: knzn | April 24, 2007 at 12:33 PM

I see relative stability when I look at TIPS as well. They are not as rock-steady as the SPF data, but that's the difference between a survey and a market price which has some inherent amount of volatility. We do aour best to make some adjustment for that, but as knzn points out its probably not perfect.

Posted by: Dave Altig | April 24, 2007 at 09:53 PM

The intellectual firepower in this thread is impressive (FT's Lex staff, several PhDs, a bond PM, an economist with an affinity for Homer (the poet, not Simpson))!

I think FT is not distinguishing between the contentions:
1. "Globalization makes it harder to conduct monetary policy" and
2. "Globalization reduces the power of central banks to use monetary policy to affect economic outcomes."

Global capital flows and securitization have disintermediated the banks previously most affected by Fed Funds rate changes. Monetary policy has gotten "harder" because the central banks' levers of power don't work so well anymore, not because of a rise in global wealth and global trade.

I'm also glad to see that we're all talking about inflation as a *generalized rise* in the prices of all (or substantially all) goods and services. Too many people think that greater short-term demand for health care services, for instance, is "inflationary," when really it just reflects a change in the mix of the aggregate spending basket. (See 1981's "Inflation: the Cost-Push Myth, brought to my attention by Bloomberg's Caroline Baum a year or so ago.)


Posted by: Bond investor | April 25, 2007 at 01:46 PM

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