Is globalisation reducing the ability of central banks to control inflation

Highlight After soaring in the 1970s, inflation in Organisation of Economic Cooperation and Development countries stabilised, coming down from 9 percent on average in the early 1980s to about 2 percent in the years before the crisis, and to a lower level in recent years. This trend coincided with the acceleration of globalisation, triggering a debate about whether global integration (of goods, labour and financial markets) could be one of the main drivers of the disinflation process and whether central banks’ ability to control inflation could be weaker as a result. We explore the different ways in which globalisation could have an impact on inflation and monetary policy transmission channels. We conclude that inflation dynamics can be affected by globalisation and that central banks should take external factors into account in their decision-making processes and in their economic models. Even if the transmission mechanisms are affected by globalisation and in particular by financial integration, ultimately, central banks retain their ability to control medium-term inflation, as long as they adopt flexible exchange rates. Executive Summary After soaring in the 1970s and early 1980s, inflation has declined significantly in all advanced countries and is now at very low levels. This movement coincided with the acceleration of globalisation, triggering a recent debate on whether globalisation could be one of the main drivers of the disinflation process, and whether the ability of central banks to control inflation could be undermined as a result. The acceleration in globalisation has mainly taken three forms that could affect inflation dynamics and monetary policy - trade integration, labour market integration and financial integration. Openness in terms of trade and finance has led to a greater sensitivity of domestic price levels to external price shocks. Trade with low-cost countries has increased massively in the last two decades, which has logically resulted in a reduction in the price of imported goods. Global competition between firms might have also reduced the pricing power of domestic companies, while the integration of billions of workers into the global labour market has likely reduced the bargaining power of domestic workers. The empirical literature shows that the contribution of globalisation to the global disinflation movement since the 1990s has been positive, but rather limited for the moment. A more important question is whether these integration trends affect the transmission mechanisms of monetary policy and reduce the ability of central banks to fulfil their mandate. The transmission channels of monetary policy could potentially be affected at various levels. First, central banks could lose their ability to control inflation if inflation becomes a function of global slack instead of being a function of domestic slack. Second, central banks could lose control of short-term rates if rates become a function of global liquidity instead of the liquidity provided by the domestic central bank. And third, central banks could lose their hold over domestic inflation and economic activity if long-term interest rates depend only on the balance between savings and investment at the global level, and not at the domestic level. It is true that the negative relationship between domestic slack and domestic inflation has changed and that that the slope of the Phillips curve has flattened since the mid-1980s. However, recent empirical studies have failed to demonstrate that globalisation had been one of the main drivers behind this trend. A more plausible explanation seems to lie in the monetary policy changes that have taken place since the mid-1980s, with the adoption of credible inflation-targeting regimes in many advanced countries. Concerning the control of central banks over the domestic yield curve, it is clear that as long as central banks retain some kind of domestic monopoly over the issuance of base money, they will be able to control the shorter end of the domestic yield curve. For long-term rates, this is less clear, however. The conundrum episode of 2004-06 in the US suggests that long-term rates can become less sensitive to short-term rates and that external factors can affect them significantly. Since the beginning of the crisis, central banks also showed that they were willing to use less conventional monetary tools in order to influence the whole yield curve, in particular when they are constrained at the short end of the curve by the zero lower bound. In any case, even if financial integration could result in a reduction of the role of the long-term interest rate channel, for countries that accept flexible rates globalisation should at the same time increase the role of the exchange rate as a transmission mechanism, because of the increased sensitivity to differences in interest rates of the demand for domestic and foreign assets. Given the potentially greater effects of external shocks on more open economies and the potential alteration of monetary policy transmission channels in more integrated financial markets, globalisation forces central banks to take external developments into account in their monetary policy decisions.