Saturday, October 10, 2009

Globalization of inflation and monetary policy

Conventional theories of monetary policy state that it is possible to maintain autonomy in monetary policy by either having floating exchange rate or with capital controls. The great moderation in inflation of the last few years has been seen as a testament to the effectiveness of monetary policy. However, there is now enough evidence to suggest that global factors contributed to keeping inflation under control during this period. This also points to the need for Central Banks to factor them in their monetary policy decisions. This post will link to a few working papers on this issue.

Claudio Borio and Andrew Filardo find that "proxies for global economic slack add considerable explanatory power to traditional benchmark inflation rate equations, even allowing for the influence of traditional indicators of external influences on domestic inflation, such as import and oil prices... the role of such global factors has been growing over time, especially since the 1990s. And in a number of cases, global factors appear to have supplanted the role of domestic measures of economic slack".

In other words, the globalization and integration of economies transmits inflationary (or dis-inflationary) pressures across national economies and increases the relevance of the (global) contributing factors in determining domestic monetary policy decisions. Factors like global labor and capacity slacks, supply-side constraints, and consumer and business demand are contributing a much larger share to domestic inflation across a broad range of countries. In view of these trends, they conclude

"1. 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... measuring global slack conditions is likely to be a challenge.

2. 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... 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.

3. 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. Together with a flattening of the slope of the Phillips curve (with respect to domestic slack), while retaining control over the long term, 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."

Ken Rogoff too feels that globalization has provided favorable environment for the success of monetary policy, in particular by lowering output growth volatility. Globalization ushers in "greater competition that weakens the power of domestic monopolies and labor unions and contributes to greater price and wage flexibility, and diminishes the output gains to be reaped from expansionary monetary policy". Rogoff claims that this would "steepen the output-inflation trade-off (Phillips curve), close the gap between natural rate of output and efficient rate of output, and further stregthen the political economy of maintaining low inflation".

He also draws attention to the convergence in real interest rates and asset prices across different markets, governed as they are by global demand and supply factors. However, this convergence conceals the increased volatility in asset prices and exchange rates. Prof Rogoff attributes this to the fact that "as long-term interest rates and risk premia fall, thereby inflating the prices of long-lived assets like housing and equity, they simultaenously become more sensitive to perceived changes to risk and the trajectory of interest rates, offsetting the volatility reduction that would otherwise come from the lower macroeconomic volatility".

Interestingly, William R White who traced the remarkable stability in inflation over the past few years to a mix of policies - dis-inflationary monetary policy, increased domestic deregulation, competition and productivity, global savings glut, and increased global competitition in all markets - found that "rising inflation, unwinding financial imbalances, or both, could easily follow the welcome stability seen to date"!

The global inflation outlook, even for the emerging economies, looks benign.

In view of the aforementioned global inflation trend and the increasing relevance of global factors in determining domestic inflation, it is important that RBI look beyond the traditional factors like WPI/CPI inflation and factor in global macroeconomic outlook while making monetary policy decisions.

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