Has globalization changed the inflation process?

Focus

This paper assesses whether globalisation should be included more comprehensively in models that forecast and explain inflation. The world economy has changed in ways which imply that global factors play a greater role in price dynamics. Key changes include greater trade flows, the greater heft of emerging markets and their impact on commodity prices, and the greater use of supply chains to shift production to cheaper locations. The increased role of these global factors could also reduce the bargaining power of local workers. 

Contribution

 Standard inflation models do not sufficiently capture these aspects of globalisation, as they tend to focus on domestic factors (such as spare production capacity ("slack") in the domestic economy and inflation expectations). Over the past decade, such models have done a poor job of explaining sharp movements in inflation in major economies. Improving them is critically important in order to better predict inflation and set monetary policy appropriately. This paper shows that a more comprehensive treatment of global factors can meaningfully improve our ability to understand how inflation evolves.

Findings

This paper uses three very different approaches to evaluate the role of global factors in the inflation process: a principal components analysis, a Phillips-curve based framework, and a trend-cycle decomposition. The results suggest that global factors, including exchange rates, oil prices, other commodity prices, slack in major economies (not just at home) and international pricing competition, can all be important determinants of inflation. Although results vary across individual countries, the role of these global factors in explaining CPI inflation rates has increased over the last decade. These results suggest that economists should not throw away the old models of inflation, but add a more comprehensive treatment of international factors and allow their role to vary over time.

Abstract

The relationship central to most inflation models, between slack and inflation, seems to have weakened. Do we need a new framework? This paper uses three very different approaches - principal components, a Phillips curve model, and trend-cycle decomposition - to show that inflation models should more explicitly and comprehensively control for changes in the global economy and allow for key parameters to adjust over time. Global factors, such as global commodity prices, global slack, exchange rates, and producer price competition can all significantly affect inflation, even after controlling for the standard domestic variables. The role of these global factors has changed over the last decade, especially the relationship between global slack, commodity prices, and producer price dispersion with CPI inflation and the cyclical component of inflation. The role of different global and domestic factors varies across countries, but as the world has become more integrated through trade and supply chains, global factors should no longer play an ancillary role in models of inflation dynamics.

JEL classification: E31, E37, E52, E58, F62

Keywords: inflation, Phillips curve, trend-cycle, price dynamics, globalization