How globalization can clarify constantly low inflation charges
Weak inflation is one of the “big challenges“Our time, according to Federal Reserve Chairman Jerome Powell. Persistently low inflation not only restricts monetary policy, but can also damage the financial system. But the inflation forecasts used by the Federal Reserve to set monetary policy have not performed very well recently. When the global financial crisis erupted in 2008 and global growth collapsed, why didn’t inflation keep falling? Why has the rate of inflation in this country remained so persistently low, given the picking up in growth in the United States and falling unemployment?
One key to the puzzle can be the predictions themselves. The frameworks that macroeconomists have relied on to predict inflation mainly use domestic variables, traced back to the “Phillips curve” of the late 1960s, which showed that inflation rises when unemployment falls. But the forces that drive our economy are not limited to our national borders. The models miss what is happening in the rest of the world.
Globalization has advanced fairly quickly over the past two decades. Trade flows have increased, emerging economies have gained economic weight and power, more and more companies are using global supply chains to move parts of their production to cheaper locations, and workers in many countries around the world have lost bargaining power. It is intuitive that these factors would affect prices. However, none of these are currently included in the standard frameworks used to forecast inflation for large countries such as the United States.
Updated models are required. my latest research adds traditional forecasting models around global economic indicators to provide a full understanding of the inflation process. These metrics capture exchange rates, oil and raw material prices, the global output gap or the difference between potential and actual production, and the role of the supply chain. The results show that global factors play a significant and increasingly important role in the dynamics of consumer price inflation, but wage inflation still appears to be largely driven by domestic factors.
It takes some context to understand why all of this is important. The Federal Reserve thinks 2 percent is a healthy level for price stability, but it has largely missed that goal in the past decade. The unemployment rate is 3.5 percent, its lowest level since 1969. In theory, this is likely to drive up wages and prices as companies compete for labor. Labor costs are expected to start rising but are not passed on to consumers in the form of higher prices.
If the overseas economy is driving inflation primarily, the Federal Reserve may be less concerned that inflation is rising too fast and more able to track what former boss Janet Yellen calls the “high pressure” economy denotes, which means that work is paramount to creation. In a tight labor market, companies are inevitably less picky about hiring. For example, they are more inclined to employ people on the fringes of business, with less experience, or with a criminal record.
If this can go on without inflation rising too quickly, that would be good. Many people who have given up looking for work are now finding employment. Many workers who are struggling to make ends meet see their wages rise. However, inflation with a more global impact also poses potential challenges. This could mean that in the event of another recession, the Federal Reserve has a more limited ability to manage the economy. Larger rate adjustments may be needed to stabilize inflation if it is less responsive to domestic conditions.
In the extreme, when inflation is increasingly determined abroad and global factors that have kept inflation low in recent years are reversed, such as: The Federal Reserve would face a difficult trade-off between supporting growth or stabilizing prices. However, this does not mean that the standard frameworks are dead. Home conditions are still important.
However, it is important that economists and policymakers update their models to take into account how globalization has changed corporate pricing. Adapting to globalization is one of the greatest economic and political challenges of our time. One of the most practical approaches is to better incorporate the effects into our inflation models.
Kristin Forbes is the Jerome and Dorothy Lemelson Professor of Economics at the Massachusetts Institute of Technology’s Sloan School of Management.