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Fri Oct 21 09:14:54 PDT 2005

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A FOREIGN AFFAIR
Oct 20th 2005  

Inflation is increasingly determined by global rather than local
economic forces

THE average inflation rate in the G7 economies rose to an estimated
3.2% in September, its highest for 13 years. The main reason for the
return of inflation is that oil has become a lot more expensive; "core"
inflation rates, which exclude oil and food, remain much lower in all
countries. But fears are mounting that higher oil prices will feed into
other prices throughout the economy, pushing inflation higher still. 

This is particularly worrying for America. On top of soaring oil
prices, companies' unit labour costs rose by 4.2% in the year to the
second quarter, mainly thanks to slower productivity growth. The rate
of growth of these costs increased by more over the year than at any
time for two decades. With energy and labour becoming conspicuously
dearer, any inflation model based on a mark-up of prices over costs
should be flashing red. Yet in the past year core inflation has not
budged. How come?

Stephen Roach, chief economist of Morgan Stanley, suggests that thanks
to globalisation, the inflation process has changed over the past three
decades in a way that has significantly weakened the link between
domestic cost pressures and inflation. He draws on an analysis in the
latest annual report of the Bank for International Settlements (BIS),
which suggests that global forces have become more important relative
to domestic factors in determining inflation in individual countries. 

According to the BIS, the correlation between core inflation and the
growth in unit labour costs in America fell to only 0.3 in 1991-2004,
from nearly 0.8 in 1965-79. The link between inflation and labour costs
also faded in other developed economies (see chart). This probably
reflects two things. First, the integration into the world economy of
China and other emerging economies with vast supplies of cheap labour
has curbed the bargaining power of workers in developed economies.
These workers therefore find it harder to secure higher wages when
inflation picks up. And second, fiercer global competition has made it
more difficult for firms to pass increases in wages through to prices.
Instead they must absorb them in their profit margins. 

As further evidence that firms are less able than they were to hand
cost increases on to their customers, the BIS found that fluctuations
in import prices also have much less impact on core inflation than they
once did. Similarly, the link between movements in exchange rates and
import prices has sharply diminished. Standard economic theory has it
that a fall in the dollar against the euro should push up the dollar
prices of European exports to America, raising America's inflation
rate. But the proportion of exchange-rate changes passed through to
import prices has fallen everywhere; in America, it has been 60% lower
since 1990 than it was in the previous 20 years. Today, exporters set
their prices for a local market and then either hedge their currency
risk or absorb currency changes in their margins. 

Increased global competition has thus limited the room for firms to
pass on higher costs. This makes a nonsense of traditional economic
models of inflation, which virtually ignore globalisation and assume
that companies set prices by adding a mark-up over unit costs, with the
size of the margin depending largely on the amount of slack in the
economy. In reality, when setting prices firms are increasingly likely
to be constrained by global competition. Given the price the market
will bear, they design and make their products as profitably as they
can. As a result, domestic cost pressures, whether in labour or energy,
no longer lead automatically to higher inflation, but are more likely
to show up as swings in profit margins.

This suggests that in forecasting inflation central banks now need to
pay less attention to domestic shifts in unemployment and capacity
utilisation and much more to the global balance between supply and
demand. The BIS's research shows that since 1990 the core rate of
inflation has become less responsive than it used to be to changes in
the output gap (a measure of economic slack) in all the main developed
economies except Britain. The ups and downs of inflation increasingly
reflect the global balance between supply and demand. 

A PREMATURE OBITUARY
The nature of inflation has thus changed. But it has not died, although
the forces of globalisation have helped to combat it. Policy blunders
by central bankers could still allow it to break out again. Indeed Don
Kohn, a governor of the Federal Reserve (and one of several potential
successors to Alan Greenspan as chairman), reckons that the impact of
China and other newly industrialising economies on inflation is often
exaggerated. In a speech last week, he drew on a Fed study which
concluded that the direct impact of cheaper Chinese imports on American
inflation was modest. However, this study ignored the indirect effects
of China on wages and the fact that cheaper Chinese goods do not just
reduce the price of imports from China but, through competition, the
price of all goods sold worldwide.

 Mr Kohn may well have underestimated the extent to which globalisation
has borne down on inflation in past years. However, more important for
policymakers today is its future effect. As Mr Kohn argued, the
emergence of new industrial giants has increased not only global supply
but also demand, particularly for oil and other raw materials. By
running large current-account surpluses these economies are currently
adding more to supply than to demand, so their net effect is
disinflationary. But this could change. If their exchange rates rose
and their domestic demand increased, said Mr Kohn, downward pressure on
prices would ease, and might one day be reversed. 

Even though globalisation has helped to hold down inflation so far,
capacity constraints will eventually appear in the global economy, just
as they always have at the national level. Globalisation does not
relieve central bankers of their responsibility for maintaining price
stability. But it may require them to steer policy by a different
compass: one that takes much more account of developments abroad. 

See this article with graphics and related items at http://www.economist.com/research/articlesBySubject/displayStory.cfm?story_id=5054125&subjectID=423172&fsrc=nwl&emailauth=%2527%2524%255F%255F%2526X%255E%255F5%2524Q%2524D%250A

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