Martín Redrado: Globalization and the determinants of domestic inflation
Remarks by Mr Martín Redrado, Governor of the Central Bank of Argentina, at the
International Symposium on "Globalisation, Inflation and Monetary Policy", organised by the
Bank of France, Paris, 7 March 2008.
* * *
Globalization has grown as a natural evolution of our era, not only incorporating more
countries into the process, but also increasing their mutual interdependence. there are
reasons to believe that this phenomenon is not harmless for domestic prices; therefore, the
critical question to discuss is: to what extent does globalization affect domestic prices and
what are the channels through which they are affected? This session - enriched,
undoubtedly, by Bill's paper1 - aims, at least, to make headway in some aspects of this
question.
My comments are divided in three parts. First, let me introduce some general remarks on the
paper. Second, I bring up some specific and constructive comments with the view of
complementing the approach of the study. And, before concluding, I focus on the prospects
for inflation in the light of current financial turbulences. I put special emphasis on the impact
of key factors for emerging market economies such as food inflation and commodity prices.
Bill's appealing work presents a detailed overview of the main potential and not necessarily
excluding explanations for the dramatic and persistent diminishing of inflation over the last 20
years. It also poses challenging policy dilemmas that arise from these trends and from the
recent developments in the world economy. As he correctly stresses, domestic and global
factors seem to have complemented to explain the decline of inflation worldwide.
The paper's central message is that the different mechanisms that have been proposed to
explain the alleged impact of globalization on domestic inflation should be seen as working
together rather than be perceived as alternative hypothesis.
And, we can hardly argue against this view. In fact, I notice a trend, mainly in this type of
seminars, to try to find a single preeminent explanation for each economic phenomenon
under study. But it will not be a fruitful approach in this case, given the complexity of the
issue and the special historical context in which it takes place, which makes it more difficult
to find a single ultimate explanatory factor. Indeed, all the offered explanations are plausible,
even though the empirical evidence is often mixed.
The author reviews the literature and underlines the limitations faced by each hypothesis to
confront the so-called "puzzles". The concept is that, even though each of the explanations is
individually unsatisfactory, the aggregate effect of all of them fits the facts and removes all
the puzzles.
It may be so, but it is difficult not to feel that this "combined" explanation lacks some sort of
quantitative support. As the author correctly points out, "the character of the shocks hitting
the global economy has changed over time and some forces affecting inflation have been
more important at some times than others", which clearly makes it a complex task to
advance into modeling the study.
Perhaps, as the author says in the introduction, macroeconomics is not really a science,
although even that is debatable as science are mostly considered so for their analytical
models rather than solely for their ability to forecast.
Nevertheless, based upon Bill's thoughtful piece of analysis, any attempt of further research
to quantify the magnitude of the impact of each factor in diminishing inflation will be very
much welcomed. It will definitely provide additional light on this issue, empowering the
author's work.
Let me turn now to the more specific points I find worth bringing up about this work.
- The author seems to agree that, to assess the relative power of the different
explanations, it is sensible not to put much faith in output-gap measures or Phillips
curve estimations (domestic gaps are difficult to estimate and global ones even
more so, disregarding the fact that it is not obvious that they can be meaningfully
defined). Indeed, the robustness of the findings in the literature is too low not to
attempt a different approach.
In my view, the definition of output gap may vary when we refer to economies that are
normally relatively close to their production frontier. Countries where incipient restructuring
processes are under way may allow them to grow above the average for a few years. Those
processes would be underestimating productive capacity and, therefore, the growth of supply
will happen without any overheating. If we add economies of scale into the equation, it is
likely that prices will not increase when output is above its empirical potential (or its potential
as estimated against a historical trend).
Furthermore, in emerging countries with somewhat informal sectors, it is already hard to
determine the effective output level, before even beginning to consider potential output. I
always recall the provocative work of Robert Hall (2005), where it is argued that we,
monetary policy makers, should not pay any attention whatsoever to neutral values for real
variables (such as the output gap). In my view we should look at output gap but do not
consider them as the "bible".
- While pointing to evidence of a decline in the devaluation pass-through in emerging
market economies, White writes that it is remarkable that inflation stayed so muted
after the Brazilian and Argentine devaluations.
Regarding the latter episode, it must be emphasized that this was mainly due to massive
unemployment before and during the crisis, after three and a half years of a continuous
decline in output. The significant excess supply of labor was by far the main factor explaining
the low pass through. Yet, during the following 12 months, inflation exceeded 40 percent,
mainly as a result of realignment in the relative prices of tradable goods. When
unemployment began to be reabsorbed, inflation pressures resumed their upward trend.
- A widespread hypothesis holds that lower headline inflation is due to lower imported
prices or larger imports of cheaper goods, as a result of lower production costs
arising from higher competition in the face of production factor globalization.
However, this essentially microeconomic explanation of such an essentially
macroeconomic phenomenon is suspicious. Let me borrow a term coined by
Cecchetti, who calls this the "accounting" theory of inflation. The problem arise
because prices affected by trade are "relative" prices. The import of a foreign
product that is cheaper than the domestic one produces a change between this
price and the other prices in the economy, while inflation is actually the aggregate
change in general nominal prices. what is fallacious is to take these two notions the
same way. This is better appreciated when taking into account that, by definition,
when the relative price of a certain good falls, there should be a rise in the price of
the other goods against which it is compared.
- The authors points out as a "puzzle" that inflation should have dropped so
dramatically in many countries with very different institutional arrangements,
different monetary policy and, above all, different exchange rate regimes. In
particular, he stresses that, during much of the period under review, many of these
countries had fixed exchange rate regimes.2
However, calling it a puzzle seems exaggerated. Lower inflation in my opinion is the
consequence of a more "responsible" management of fiscal, monetary and wages policies,
which might be a result of a growing awareness of the costs of inflation. These policies can
be put into effect by diverse means and through different institutional setups. There isn't a
one-size-fits-all sort of recipe for implementing a more responsible economic policy.
In the paper, the role played by monetary, fiscal and wage policies seems to be rather
underestimated. In my view, the contribution of better and sounder policies to explain the
trend of domestic inflation in both industrial countries (ICs) and emerging markets economies
(EMEs) over the last 20 years has been crucial. The empirical literature has provided vast
evidence, particularly for the united sates, that changes in policy objectives and management
have been important to explain the decline of inflation since mid 80's.
In developing countries, where fiscal imbalances were a main source of monetary instability
and inflation, improvements in tax and expenditure policies contributed significantly to explain
the decline of inflation since the early 90's.
- Bill also mentions that it is strange for inflation to remain so low given that monetary
conditions seem to have been particularly lax for a rather long period of time. This is
a true puzzle. However, considering the recent trend in certain variables related to
the opportunity cost of keeping money, as well as the high global growth in the past
years.
We cannot rule out that, in real terms, the demand for money has genuinely increased.
Conclusive evidence to make this point is hard to find yet. Further research on the subject
should add some light on this issue.
- White remarks the low cost of buying protection against corporate bankruptcies until
the outbreak of the August crisis. he compares the cost as of mid July 2007 with the
cost in the recessions of 1981 and 1991. However, the comparison is not totally
valid because the depth and liquidity of the cds market in 2007 was enormously
higher than in 1981 and 1991.
- Let me emphasize though, that financial integration should be given a larger role in
the discussion between globalization and inflation. In particular, when assessing the
effectiveness, credibility and commitment of monetary policy in emerging market to
deal with inflation and inflation expectations. In my opinion, the depth of the financial
system and its integration with capital markets has a powerful disciplinary effect on
monetary policy as it reduces incentives to pursue expansionary policies as foreign
capital would flow out to other markets with more predictable returns.
Also, financial development allows agents to substitute assets in local currency to protect
themselves against inflation, restraining again the discretionary use of monetary policy.
Moreover, financial integration allows financing current accounts deficits, weakening the link
between domestic output and demand. Then, an increase in domestic demand would
translate into larger imports and not necessarily into higher prices.
My opinion is that "financial integration" measure (like the sum of foreign assets and liabilities
over GDP) seem to be better indicators of globalization as a "price container" than "real
economy" measures (such as the trade to GDP ratio).
- White mentions the possible re-emergence of inflation as one of the two main
problems going forward (the other being an unwinding of the various "imbalances").
But he does not discuss one very interesting aspect of this development: the recent
pick up in inflation at the international level is to a great extent, a consequence of
the process of catching up of billions of people in the developing countries to levels
of consumption closer to those in developed countries, including changes in dietary
patterns. Let me hypothesize that we are approaching a true law of one price, with
developed countries converging top-down and emerging countries bottom-up.
- There is a risk that the insolvency that lies at the base of the current crisis (although
manifested until now largely in a lack of liquidity) may impart an inflationary bias to
the system and that the unwinding of the imbalances leads to more inflation. The
hypothesis that states that globalization may reduce policymakers' ability (and,
consequently, incentives) to temporarily stimulate output was perhaps never heeded
by policymakers. Certainly, they do not seem to be acting in accordance to it now.
- Also, we should not forget that there is an additional "insolvency" looming in the
horizon: the unfunded liabilities of social security systems in developed countries.
There be a temptation to inflate that burden away. Thus, there are both short-term
and long-term reasons to expect a higher inflation rate in the future than during the
"great moderation" period.
Let me turn now to my last comments.
Regarding commodity prices and their impact on inflation, the increasing trend is largely due
to its own fundamentals, including above all the major growth in emerging countries over the
past few years, biofuel development and structural changes in livestock feeding.
Nevertheless, seasonal factors are also influential; among them, it is worth mentioning
supply shocks from climate hazard and geopolitical conflicts, and the increase in speculative
demand to protect against us dollar depreciation and financial asset loss, and inflation.
Agricultural commodities in my view are more resilient to a recessionary outlook by their
lower income elasticity and the relative strong fundamentals of emerging economies, where
demand increased substantially.
Soft commodities accumulate increases ranging from 100% to 150% since the beginning of
the century with an acceleration in 2007-2008 that is leading to historically low stock to
consumption ratios.
In the cases of soy and corn, where Argentina is a world-class producer, demand is
consistently outpacing supply due to a hike in demand for food in the emerging world and a
growing demand for biofuels in the industrial countries. While supply stays in historically high
levels it cannot keep up with the demand forces. Just to give you an example, corn
inventories are 30% below the average of the last ten years. The outlook of financial volatility
will continue to be a source of speculative demand for commodities as hedge for inflation. In
addition, the continuity of monetary policies aimed at reducing reference rates would likewise
aid speculative demand for commodities.
As the paper points out, food and energy impacted on the acceleration of consumer prices,
especially in emerging countries, where foodstuffs have a significant weight in the
consumption basket. However, the prices of other goods and services remained relatively
contained. insofar as structural factors prevail over temporary ones, food and energy prices
would more likely have second-round effects on other goods and services through cost
pressures. While by the end of 2007 headline inflation accelerated in close connection with
the behavior of core price indices, these second round effects have not materialized yet.
Food prices can potentially lead to wage demands which, given the stickiness of this
component of the cost structure of the private sector, would result in subsequent increases in
general level. However the risk is more evident in emerging countries than in developed
ones. For example, the average wage in China increased by 26.9 percent year-over-year in
the third quarter of 2007, significantly above the average of the past five years (16.8 percent)
and well above the consumer price index increase. So, there might be some evidence that
the downward pressures in consumer goods that come from china are reaching an end.
To sum up, we central bankers around the globe face significant dilemmas and challenges.
In spite of the opposing forces on inflation prospects, I expect that the slowdown in global
economy will ease excess demand pressures and at the same time it will contribute to
moderate marginally the increases in commodity prices.
However, due to the structural factors in the agri-bussiness sector worldwide, I do not expect
this scenario to change significantly.
Emerging markets economies seem to be better prepared to face this new scenario and the
slight acceleration in prices. This is mainly due to sound macroeconomic policies and a
favorable international context with commodity prices facing a long favorable cycle. And, in
my view, policy makers in emerging markets are well prepared to face some social tensions
that could come as a result of the higher commodities prices.
In a nutshell, the challenges that globalization poses due to its impact on domestic prices are
significant. But, now policy makers around the globe seem to understand that recipes vary
from one case to the other in this complex scenario. This progress is, obviously, welcomed.
Especially for us, emerging markets' policy makers, as we have to catch up with growth and
macroeconomic stability, deal with the tensions derived from buoyant economies and, most
importantly, build credible institutions.
In fact, it is more a synchronic than a sequential two-fold challenge: advancing towards the
development of our economies and constructing solid institutions simultaneously. To
implement these policies effectively, the only possible way is to be firm in the implementation
of consistent (I mean consistent with the history and idiosyncrasies of each economy),
flexible and gradualist approach that has guided us in recent years.
References
- Ball, Laurence (2006), "Has globalization changed inflation?, NBER working paper no.
12687, November.
- Hall, Robert (2005) "Separating the business cycle from other economic fluctuations, in the
Greenspan era: lessons for the future", Federal Reserve Bank of Kansas City, pp. 133-179,
August 2005.
- Ihrig, Jane, Steven B. Kamin, Deborah Lindner and Jaime Marquez (2007), "Some simple
tests of the globalization and inflation hypothesis", Board of Governors of the Federal
Reserve, International Finance discussion papers, number 891, April.
- International Monetary Fund (2006), "How has globalization affected inflation?", World
Economic Outlook, chapter iii, April.
- International Monetary Fund (2005), "Globalization and external imbalances", World
Economic Outlook, chapter iii, April.
- Kroszner, Randall S. (2007), "Globalization and capital markets: implications for inflation
and the yield curve", speech at the Center for Financial Stability (CEF), Buenos Aires,
Argentina, May.
- Wynee, Mark A. and Erasmus K. Kersting (2007), "Openness and inflation", Federal
Reserve Bank of Dallas, staff papers, no. 2, April.