How globalization may explain consistently low inflation rates

How globalization may explain consistently low inflation rates
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Weak inflation is one of the “major challenges” of our time, according to Federal Reserve Chairman Jerome Powell. Not only does persistently low inflation limit the scope of monetary policy, it may also have a damaging impact on the financial system. But the inflation forecasts used by the Federal Reserve to set monetary policy have not been performing very well lately. When the global financial crisis erupted in 2008 and growth collapsed around the world, why did inflation not fall further? As growth has picked up in the United States and unemployment has gone down, why has the inflation rate in this country remained so stubbornly low?

One key to the puzzle may be the forecasts themselves. The frameworks that macroeconomists have relied on to predict inflation primarily use domestic variables dating back to the “Phillips Curve” of the late 1960s which showed that inflation increases when unemployment falls. But the forces that drive our economy are not only confined within our national borders. The models miss what is happening across the rest of the world.

Over the last two decades, globalization has proceeded quite rapidly. Trade flows have increased, emerging markets have achieved greater economic heft and power, more and more companies are using global supply chains to shift parts of their production to cheaper locations, and workers have lost bargaining power in many countries across the world. It is intuitive that these factors would have an impact on prices. However, none of them are currently captured in the standard frameworks that are used to forecast inflation for major countries such as the United States.

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Updated models are necessary. My latest research adds global economic indicators to traditional forecasting models to provide a comprehensive understanding of the inflation process. These metrics capture exchange rates, oil and commodity prices, the world output gap, or the difference between potential output and actual output, and the supply chain role. 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 determined by domestic factors.

Some context is needed to understand why this all matters. The Federal Reserve considers 2 percent a healthy level for price stability, but it has failed to reach that target for most of the last decade. The unemployment rate hovers around 3.5 percent, the lowest level since 1969. In theory this should propel wages and prices higher as companies must compete for workers. Labor costs are starting to rise as expected, however, they are not getting passed forward to consumers in the form of higher prices.

If inflation is mostly determined by the economics overseas, the Federal Reserve could be less concerned about inflation picking up too quickly and be more able to pursue, what former chief Janet Yellen refers to as a “high pressure” economy, meaning one that prioritizes job creation. In a tight labor market, companies are, out of necessity, less choosy about who they hire. They are, for instance, more apt to employ people on the fringes of the economy, with less experience or with criminal records.

If this can continue without inflation picking up too quickly, it would be a good thing. Many people who had given up on finding a job can now find gainful employment. Many workers who struggle to make ends meet are starting to see their wages pick up. However, more globally influenced inflation also poses potential challenges. It could mean that the Federal Reserve would have a more limited ability to steer the economy should another recession occur. Larger adjustments in interest rates might be needed to steady inflation if it is less responsive to domestic conditions.

In the extreme, if inflation is increasingly determined abroad and global factors that have kept inflation low over the last few years reverse, like movement away from global supply chains as trade tensions increase, then the United States could suddenly experience a sharp increase in inflation. The Federal Reserve would face a difficult tradeoff between supporting growth or stabilizing prices. Yet this does not mean that the standard frameworks are dead. Conditions at home are still important.

However, it is important that economists and policymakers update their models to account for the ways in which globalization has changed how companies set prices. Adjust to globalization marks one of the greatest economic and political challenges of our time. One of the most practical places to start is better incorporating its effects in our inflation models.

Kristin Forbes is the Jerome and Dorothy Lemelson professor of economics at the Massachusetts Institute of Technology Sloan School of Management.