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Claudio Borio and Andrew FilardoBank for International Settlements

Globalisation and inflation:

New cross-country evidence on the global determinants of domestic inflation

13th Dubrovnik Economic Conference29 June, 2007

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Road map

Do we need new theories of inflation?

“Theory”

Empirical evidence

Policy implications and conclusions

33

Motivation

“Over the past two decades, inflation has fallen notably, virtually worldwide, as has economic volatility. Although a complete understanding of the reasons remains elusive, globalisation and innovation would appear essential elements of any paradigm capable of explaining the events of the past ten years”.

Alan Greenspan (2005)

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Do we need new theories?

No & Yes

• No:

Still, inflation is always and everywhere a monetary phenomenon!

• Yes:

Evidence is accumulating that the inflation process is changing in various ways.

Today, we focus on the channels influencing goods and services markets, from a top-down perspective.

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Stylised facts about global inflation

Also see, Ciccarelli and Mojon (2005), Mumtaz and Surico (2006).

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Some stylised facts about globalisation

Direct and indirect channels important!

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Some stylised facts – G10 wage shares

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Inflation trend (BIS 2006)

Globalisation has…

… lowered the cost of disinflation

… helped moderate business cycles

… rewarded good policy frameworks

… reduced downward rigidities

… boosted central bank credibility

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Inflation trend

Globalisation has…

… lowered the cost of disinflation

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Inflation trend

Globalisation has…

… lowered the cost of disinflation

… helped moderate business cycles

… rewarded good policy frameworks

… reduced downward rigidities

… boosted central bank credibility

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The cyclical component

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The cyclical component

• What is the role of global factors in the domestic inflation process?

• We know that the inflation process has changed

• To many central banks, domestic developments might seem sufficient to explain the changes. But are the domestic changes symptoms or are they truly the causal factors?

• At this point, we are only starting to explore the key implications – many daunting puzzles remain.

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The “theory”

Country-centric vs globe-centric views

Country-centric view

Traditional view

- Phillips curve

- Domestic measures of slack matter

- Monetary policymakers have tight control of the inflation process

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Country-centric view

Key assumptions:

1. Textbook flexible exchange rates or

2. Fairly closed economy

- Limited substitutability (across products and factor inputs)

- To the extent that the tradable sector matters, import prices are sufficient statistics

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Globe-centric view

Globe-centric view

Newer view

- Traditional Phillips curve not well specified

- Global measures of slack matter

- Monetary policymakers have much looser control of the inflation process

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Globe-centric view

Key assumptions:

1. Deviations from ideal flexible exchange rate regime (though not necessarily a fixed regime)

2. Globalised economy

- high substitutability across products and/or factor inputs (Chen, Imbs and Scott (2004))

- Global capacity constraints for goods and factor inputs key

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Exploring global output gaps

Several Key Findings!

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Top-down methodology

Augmented Phillips curve approach

What measure of slack is relevant?

Borio and Filardo (2007): “Globalisation and inflation: new cross country evidence on the global determinants of domestic inflation”

slack) f(economic Inflation

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Key findings

Country-centric benchmark specification shifting

tDttt Gapc 11

inflation constant lagged inflation

domestic output

gap

Estimated country by country, for sub-samples (1980:Q1-92:Q4 and 1993:Q1-2005:Q3); CPI inflation; OECD output gaps

2020

Declining importance of domestic gap

Sensitivity of inflation to domestic output gaps has fallen

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Specification issue

1 1iGU D

t t t ttc Gap Gap

De-trended inflation

constant global output

gap

domestic output

gap

Far from perfect, but instructive and illustrative

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Global gaps – measurement issues

5 different alternatives

,

,

i i

k

G G Dj j k

k K

Gap w Gap

Weighted averageof domestic output gapsVarious versions eg tradeweighted FX weighted

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Global gaps

Trade-weighted version – W1

j

kjkjWkjw exports and imports total

exportimport ,,1,

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Global gaps

Import-weighted version – W2

j

,2, imports total

import kjWkjw

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Global gaps

Exchange rate-weighted version – W3

kj

kjWkj f

fw

,

,3, where

m

mf

kj

kj

kj 1exp1

1exp

*2,

,

,

k) and j countriesfor rate exchange bilateralUS(, ncorrelatiokj

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Global gaps

Exchange rate adjusted trade-weighted version – W4

)(

exportimport total

exportimport,

kj,kj,

4, numerators

fw

kjWkj

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Global gaps

GDP-weighted version – WG

GDP World

GDP jWGjw

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Pooled regression evidence:Scatter plot with global gap

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WtGap

D tU t

tGap

c1

1985-2005Now

1972-1992

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WtGap

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Rising importance of the global gap

Coefficient on global gap

Pooled 16 OECD Countries

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Rising importance of the global gapAverage of 16 OECD country-specific regressions

( )

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Robustness to control variablesAccounts for traditional and non-traditional control variables

tUtt variablescontrol...

Supply/cost shocksDomestic variables

Import price growth Oil price growth ULC growth

Global variablesGlobal unit labour costsGlobal WPI

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Global input prices and inflation – tight correlation

Inflation gap: de-trended CPI inflation, 16 OECD economies. Input prices: Composite JPMorgan Chase input price index covering purchases of goods for manufacturing industries, and goods and staff costs for service industries; values above (below) 50 indicate an increase (decrease).

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Goods and services marketsSome evidence on sectoral markets:The correlation of global measures of slack with manufacturing is generally stronger than with services … as might be expected!

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Tentative conclusions

Prima facie evidence that we may need to think in a less country-centric, ie more globe-

centric, way about the key determinants of domestic inflation – direct and indirect channels of influence important

This may help to explain the deterioration of domestic output gap estimates of late, and to suggest ways to “fix” existing models

And, globalisation may be making domestic monetary policy less effective!

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Policy implications

1. Globalisation has altered traditional policy guideposts

Domestic slack has become less reliable

Global slack has become more important determinant of domestic inflation

Other dimensions of globalisation exacerbate these changes – NAIRU, natural rate of interest

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Policy implications

Policy challenge:

- relying too heavily on domestic slack can lead policymakers astray

- Looking forward – key risk is global spare capacity and price stability. So far a safety valve.

- But what next?

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Policy implications

2. Financial globalisation complicates this

- Financial globalisation has weakened the link between policy rates and market rates

- Room for manoeuvre may be shrinking

- At the current policy juncture, this tendency may have implications for financial imbalances

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Current policy implicationsSmooth sailing or impending crisis?

Money, Credit and Asset Prices

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Mitigating the global implications

1. Globalisation has altered traditional policy guideposts - improved monitoring of external developments

2. Renewed interest in boosting analytic efforts to understand the many facets of globalisation

i. International business cycle models• Spillovers across national borders• Trade linkages as well as contestability

ii. Top-down approaches rather than bottom up

iii. Global dimensions of the monetary policy transmission mechanism

3. Multilateral policy implications

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Important puzzles – top-down approach

Specification issue & robustness

1 1 1iGD

t t t ttc Gap Gap

1 1iGU D

t t t ttc Gap Gap (BF)

(AR)

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- - - “true” value conventional AR specification B-F specification

0

5

10

15

20

-0.1 0.1 0.3 0.5 0.7 0.9

0

5

10

15

20

-0.3 -0.1 0.1 0.3 0.5 0.7

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Conventional AR model severely bias!

,AR BF AR

Small-sample probability density function

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Thank you

Think globally! Act locally!

more

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References

Borio and Filardo (2007): “Globalisation and inflation: new cross country evidence on the global determinants of domestic inflation” and references therein; BIS Annual Report (2006).

Recent speeches: Weber (June 2007); Kohn (March 2007), Bernanke (March 2007)

Recent papers:

Pain, Koske and Sollie (2006)

Castelnuovo (2006)

Ihrig, Kamin, Lindner and Marquez (2007)

Razin and Binyamini (2007)