Wednesday, December 11, 2019

Inflation is a global issue, but what if globalization reverses?

The US has a 2% inflation target. Other countries have similar targets. All are frustrated by the their inability to consistently reach those targets even though they have tools that should push prices higher. The US is an especially interesting case given that current unemployment is so low. 

However, the latest CPI numbers suggest that the US is at the target; slightly higher for the core CPI and slightly lower for the headline numbers. The problem will be staying at the target; consequently, there is a strong reason to place a hold on any further Fed cuts at this time. 

Nevertheless, there is still a need to understand the drivers of inflation. One answer is that inflation is not just a domestic slack issue but a global phenomenon. There is a link between inflation in the rest of the world and the US. This is the conclusion of one leading inflation researcher, Kristin Forbes, who wrote an extensive paper on this issue in the Brookings Papers on Economic Activity "Inflation Dynamics: Dead, Dormant, or Determined Abroad".

Her conclusion is that CPI inflation across countries has become more synchronized since the Financial Crisis in 2008; however, this synchronization has not carried over to core inflation and wages. The inflation components tied to core domestic pressures are still local. Still, Forbes finds that global factors such as commodity prices, world economic slack, exchange rates, and global value chains all impact headline inflation. The world has gotten more connected with respect to inflation and accounting for this globalization will improve median prediction error for inflation by about 12%. There may still be a Philips curve trade-off but it has flattened since the Financial Crisis. Of  course, these conclusions are generalizations across all countries. The impact of global versus domestic inflation factors will vary across countries. 

While there has been an increase in inflation globalization, the obvious next question is whether a reversal of globalization will lead to more localization of inflation. This would mean more potential inflation dispersion and a greater impact from local slack over global economic slack. It also means that core and headline may start to have a tighter relationship. 

Any diminished global effect will have a carry-over effect on global interest rate dispersion and currency dislocations. This is unlikely to be a short-term effect, yet it should be worth watching for greater inflation dispersion. Overall, the inflation question is more complex for a globalized economic system over a closed economy; consequently, following international developments is essential for effective inflation forecasts.

No comments: