Is Globalisation Reducing The Ability of Central Banks to Control Inflation?

Gregory Claeys and Guntram B. Wolff in their paper “Is Globalisation Reducing The Ability of Central Banks to Control Inflation?”, explored the different ways in which globalisation could have an impact on inflation and monetary policy transmission channels. They concluded that inflation dynamics can be affected by globalisation and that central banks should take external factors into account in their decision-making processes and in their economic models.

There are three forms by which acceleration in globalisation can affect the inflation dynamics and monetary policy:

  • trade integration
  • labour market integration
  • financial integration

From the paper,

Openness in terms of trade and finance has led to a greater sensitivity of domestic price levels to external price shocks. Trade with low-cost countries has increased massively in the last two decades, which has logically resulted in a reduction in the price of imported goods. Global competition between firms might have also reduced the pricing power of domestic companies,while the integration of billions of workers into the global labour market has likely reduced the bargaining power of domestic workers.The empirical literature shows that the contribution of globalisation to the global disinflation movement since the 1990s has been positive, but rather limited for the moment.

A more important question is whether these integration trends affect the transmission mechanisms of monetary policy and reduce the ability of central banks to fulfil their mandate.

How do these integration trends affect the transmission mechanism?

  • Central banks could lose their ability to control inflation if inflation becomes a function of global slack instead of being a function of domestic slack.
  • Central banks could lose control of short-term rates if rates become a function of global liquidity instead of the liquidity provided by the domestic central bank.
  • Central banks could lose their hold over domestic inflation and economic activity if long-term interest rates depend only on the balance between savings and investment at the global level, and not at the domestic level.

Empirically, of course, fluctuations in global prices can have major temporary effects on domestic prices. Figure 6 shows that energy and (to a lesser extent) food price inflation are major determinants of euro-area headline inflation. These fluctuations pose a significant challenge to central banks. Some central banks have reacted by emphasising that their inflation goal is centred on core inflation measures . Others, such as the ECB, carefully document that core inflation measures suffer from a number of drawbacks. Instead, the ECB emphasises the medium-term nature of its inflation goal. The aim is not to reach an inflation rate of close to 2 percent every year but rather to have such an inflation rate in the medium term. In its focus on the medium term, the ECB should therefore tolerate the effects of temporary external price shocks (coming from commodity prices in particular), as long as these shocks do not have second-round effects and do not disanchor inflation expectations from the 2 percent target. On the contrary, if inflation in the price of important imported goods is on a long-term downward trajectory, this dampens inflation even in the medium term and monetary policy would then have to aim to increase the inflation rate of domestically produced goods in order to reach its 2 percent target.

Financial integration might reduce the efficacy of such monetary policy, but other counter-forces also come into play. For a small, open, emerging economy, the effectiveness of its monetary policy will be reduced by greater global financial integration. Bigger open economies however, such as the US and the euro area will not be as vulnerable and will find that their monetary policy still retain its bite. Good news then, for Mr Draghi.

From the FT, the most recent reading for the eurozone was 1 per cent for the year to October, up from 0.9 per cent the previous month. Mr Draghi said today that signs of a sustained turnaround in the core inflation have somewhat weakened.

The ECB chief is likely to unleash a more aggressive quantitative easing package and consider cutting interest rates next month. “The option of doing nothing would go against price stability,” Mr Draghi said in a dovish set of remarks. “That is what will outline the strategy for the coming months.”

The paper concludes, “In an increasingly integrated world, central banks need to take into account global economic developments and their spillovers onto the domestic economy. But through their control over short term nominal interest rates and through their ability to affect long-term interest rates directly through asset purchases, central banks have powerful instruments to steer financial conditions that affect demand and inflation.”

The key phrases here are ‘spillovers’ and ‘powerful instruments’, pertinent to policy makers facing the constraints of the zero lower bound and employing unconventional monetary policy.

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