During his term as Managing Director, Michel Camdessus oversaw the second great wave of globalisation. The Berlin Wall fell, capital controls were liberalised, the euro was constructed, and China prepared to join the WTO. Product and financial markets became increasingly integrated, with trade growing at an annual rate of 10% and capital flows of 20%. The effective global labour force doubled, and more than a billion people were lifted out of poverty.
Central banks are now grappling with one consequence of such enormous achievements – the impact of globalisation on inflation.
All central banks must consider the cyclical relationship between global slack and domestic inflation; the degree to which secular forces from globalisation affect local inflation dynamics; and how global factors influence the stance of domestic monetary policy itself. And now some central banks may need to consider the implications for price stability if the process of globalisation were to slow or go into reverse.
These issues are particularly relevant to the Bank of England as the UK inflation outlook will be importantly influenced for some time by a process of de-integration under Brexit.
Today, I would like to draw on this example to illustrate how global factors influence domestic inflation dynamics and the ability of central banks to achieve price stability.
II. Globalisation and Inflation
While the global Phillips Curve appears alive and well (Chart 1), globalisation has been accompanied by a weakening in the relationship between domestic slack and domestic inflation (Chart 2), and by a corresponding strengthening in the relationship between global forces and domestic prices.
With correlations of headline CPI inflation rates as elevated today as during the first oil shock (Chart 3a), some contend that global forces have become dominant – a conviction reinforced by the ‘missing disinflations’ in the wake of the global financial crisis and by the current series of wage puzzles in advanced economies. There are even suggestions that monetary policy frameworks should be overhauled – potentially lowering the inflation target – in response globalisation’s growing impact.
Some perspective is required.
Wage puzzles in advanced economies can be partly solved by recognising that post-crisis structural reforms have lowered natural rates of unemployment, by broadening measures of labour market slack to include involuntary underemployment, and by acknowledging that weak wages are one consequence of sustained poor productivity growth.
More broadly, the recent high correlations of headline inflation rates have been driven by very large global shocks including the financial crisis and the commodity super cycle. Core inflation rates have actually exhibited little co-movement but rather have varied with (divergent) underlying economic conditions (Chart 3b).
Central banks have (thus far) been able to maintain their monetary sovereignty, achieving their mandates by offsetting the secular disinflationary forces from global integration.
None of this, however, is to downplay current challenges of maintaining price stability in the face of global forces. The combination of the growing contestability of markets and prolonged synchronised weak demand may be restraining wage expectations. Moreover, technological changes, particularly those which could globalise markets for many services, may extend and deepen trend global disinflation. And, the global financial cycle could exacerbate the challenges of returning domestic inflation to target, particularly given the proximity of interest rates to the effective lower bound.
Charting a path for monetary policy in this environment thus requires a nuanced understanding of how globalisation both affects inflation and influences the stance of monetary policy. It is to these I will now turn.
Global Influences on Domestic Inflation
In a closed economy, inflationary pressures depend on developments in domestic costs, which in turn depend on domestic spare capacity, or the balance of domestic supply and demand.
Opening up the economy changes this relationship in three ways.
Most straightforwardly, external demand exerts pressure on domestic resource utilisation and therefore domestic inflation. The importance of this channel has steadily increased for most of the past half century (Chart 4).
Next, in an open economy, prices of imports affect domestic inflation both directly – through the final goods and services bought by households – and indirectly – through the prices of imported intermediates used in the production of final goods and services in the consumption basket.
For years the direct effect has imparted a steady disinflationary bias. The integration of lower-cost producers into the global economy acts like an increase in potential supply for advanced economies, raising the level of spending that is consistent with inflation at target.8 Thus far, this disinflationary effect has mostly affected the prices of goods (Chart 5), as trade in goods has been liberalised to a much greater extent than services. Monetary policy makers in advanced economies have responded by accommodating relatively higher services price inflation in order to meet their inflation objectives. For example, in the UK core goods prices fell an average of 0.3% over the past two decades, services prices rose by an average of 3.4% and total CPI inflation was on average at target.
Globalisation has also led to a dramatic increase in the use of imported intermediates in domestic production. The ICT revolution has made a great unbundling of production into global value chains possible, and large wage differentials have made doing so profitable. Intermediate goods trade has represented 80% of the increase in total trade over the past two decades (Chart 6), driving up the value added of imports as a share from 10% of exports in 1990 to around 20% in 2015.
This expansion in global value chains has led to greater synchronisation of producer price inflation across countries. And it has increased the sensitivity of domestic inflation to global inflationary pressures while reducing its responsiveness to changes in domestic slack. Research by the BIS indicates that a doubling in the share of imported intermediates in GDP causes the importance of global factors for domestic inflation to double as well. Consistent with that, research at the Bank of England indicates that each 1 percentage point increase in the import intensity of consumption reduces the sensitivity of inflation to domestic slack by 1 per cent, and that the strength of this effect varies with the ease with which producers can switch between imported intermediates and domestic alternatives.
Monetary policy makers must take the effects of intermediate trade into account since, unlike commodity shocks, import price changes take time to work through supply chains into final goods prices and therefore affect inflation at the policy-relevant horizon.
Labour markets provide a third channel through which globalisation affects domestic inflation. To be clear, globalisation is far from the only factor that has been affecting labour markets in recent decades – and arguably, as work by the IMF and others has shown, technological progress has played a more significant role. Technology, not globalisation, is estimated to be the main reason why labour’s share of income has been falling across advanced economies.
But that does not mean global effects are absent.
The doubling of the effective global labour pool represents a huge, positive supply shock for the global economy. It has encouraged the shift of the production of goods and services that use lower-skilled labour intensively to countries with an abundance of lower-skilled workers – predominantly emerging market economies – while production of goods and services requiring more highly skilled labour has concentrated in countries with a greater share of higher skilled labour – predominantly advanced economies. The growing ability to split production components and tasks through global value chains has amplified this effect.
Globalisation has also increased the contestability of labour markets, weakening the extent to which slack in domestic labour markets influences domestic inflationary pressures.20 That is, the increased ease with which activities can be off-shored or domestic vacancies filled by sourcing workers from abroad may have reduced the relative bargaining power and wage expectations of workers. While it is difficult to measure precisely, available evidence suggests that contestability effects could be significant. Greater openness appears to have reduced the sensitivity of wages to domestic labour market conditions and led to growth in domestic unit labour costs (ULCs) becoming more closely tied to global ULC growth.
Overall, the greater global supply of labour has lowered the relative wages of lower-skilled workers in advanced economies. While this reduces inflationary pressures in the economy as a whole it has contributed to a long and painful period of adjustment for lower-skilled workers. The secular disinflationary effects from this steady integration of additional workers into the global labour market need to be taken into account in addition to the cyclical inflationary pressures from changes in labour market slack.
Changes in external demand will cause a shift along the Phillips Curve, as domestic companies adjust capacity utilisation in response.
The series of positive supply shocks from increased product and labour market integration cause parallel shifts down in the Phillips Curve. These downward shifts will persist as long as integration continues. This may take a while, not least because the advent of digital platforms may extend these processes to a much broader range of goods and services markets.25 The domestic economy needs to be run with tighter spare capacity to accommodate these disinflationary effects.
The increased competitive forces from globalisation (both actual and contestable) have also acted through product and labour markets to decrease the responsiveness of inflation to domestic slack, flattening the Phillips Curve slope (3).
Monetary policy must take all these effects into account and, on balance, run the domestic economy with tighter spare capacity in order to accommodate them.
III. Global Influences on the Stance of Monetary Policy
Just as global factors affect the relationship between domestic slack and inflation, they influence the monetary policy setting needed to achieve the inflation target. In particular, global integration affects the transmission mechanism of domestic monetary policy, the degree of spillovers from foreign monetary policies, and the equilibrium rate of interest itself.
For the past thirty years, a number of profound forces in the world economy has pushed down on the level of world real interest rates by as much as 450 basis points (Charts 7 and 8). These forces include the lower relative price of capital (in part as a consequence of the de-materialising of investment), higher costs of financial intermediation (due to financial reforms), lower public investment and greater private deleveraging. Two other factors – demographics and the distribution of income – merit particular attention.
Bank research estimates that the increased retirement savings as a result of global population ageing and longer life expectancy have lowered the global real interest rate by around 140 basis points since 1990 and they could lead to a further 35 basis point fall by 2025. The crucial point is that these effects should persist after the demographic trends have stabilised because the stock, not the flow, of savings is what matters.
By changing the distribution of income, the global integration of labour markets may also lower global R*. The changes in relative wages in advanced economies have shifted income towards skilled workers, who have a relatively higher propensity to save. Rising incomes in emerging market economies may be reinforcing that effect as saving rates are structurally higher in emerging market economies, reflecting a variety of factors including different social safety regimes.
The high mobility of capital across borders means that returns to capital will move closely together across countries, with any marked divergences arbitraged.
As a consequence, global factors are the main drivers of domestic long-run real rates at both high and low frequencies (Charts 9 and 10). For example, Bank of England analysis suggests that about 75% of the movement in UK long-run equilibrium rates is driven by global factors (Chart 10).33 Estimates by economists at the Federal Reserve deliver similar results (Chart 11).
The presence of borrowers and lenders operating in multiple currencies and in multiple countries creates multiple channels through which developments in financial conditions can be transmitted across countries.35 For example, changes in sentiment and risk aversion can lead to international co-movement in term premia, affecting collateral valuations and so borrowing conditions.
Work by researchers at the Bank of England, building on analysis by the IMF, shows that a single global factor accounts for more than 40% of the variation in domestic financial conditions across advanced economies. For the UK, which hosts the world’s leading global financial centre, the relationship is much tighter, at 70%.
Highlighting the openness of the UK economy and financial system, a third of the business-cycle variation in the UK policy rate can be attributed to shocks that originate abroad.
One important channel of global spillovers is of course monetary policy. In coming years, it is reasonable to expect global term premia to rise as net asset purchases could shift significantly from the situation during the past four years when all net issuance within the G4 was effectively absorbed (Table 1).
About Mark Carney
Mark Carney is the Governor of the Bank of England and Chairman of the Monetary Policy Committee, Financial Policy Committee, and the Board of the Prudential Regulation Authority. His appointment as Governor was approved by Her Majesty the Queen on November 26, 2012. The Governor joined the Bank on July 1, 2013. In addition to his duties as Governor of the Bank of England, he serves as Chairman of the Financial Stability Board (FSB), First Vice-Chair of the European Systemic Risk Board, a member of the Group of Thirty and the Board of Trustees of the World Economic Forum. After a 13-year career with Goldman Sachs in its London, Tokyo, New York, and Toronto offices, Mr. Carney was appointed Deputy Governor of the Bank of Canada in August 2003. In November 2004, he left the Bank of Canada to become Senior Associate Deputy Minister of Finance. He held this position until his appointment as Governor of the Bank of Canada in February 2008. Mark Carney served as Governor of the Bank of Canada and Chairman of its Board of Directors until June 1, 2013.
About Michel Camdessus
Michel Camdessus assumed office as the seventh Managing Director and Chairman of the Executive Board of the International Monetary Fund (IMF) in January 1987, and served until February 2000. Mr. Camdessus is the longest-serving Managing Director of the IMF to date. Previously, he held several senior positions in the French government, becoming Director of the Treasury in 1982. From 1978 to 1984, he also served as Chairman of the Paris Club, and was Chairman of the Monetary Committee of the European Economic Community from 1982 to 1984. Mr. Camdessus served as Deputy Governor of the Banque de France, and Governor of the Banque de France from November 1984 until his appointment as Managing Director of the IMF. He is currently an Honorary Governor of the Banque de France and a member of the Africa Progress Panel, a group of 10 distinguished individuals who advocate at the highest levels for equitable and sustainable development in Africa.