Mark Carney: Inflation in a globalised world
Remarks by Mr Mark Carney, Governor of the Bank of England and Chairman of the
Financial Stability Board, at the Federal Reserve Bank of Kansas City Economic Symposium,
Jackson Hole, Wyoming, 29 August 2015.
* * *
Accompanying charts can be found at the end of the speech or on the Bank of England's website.
I am grateful to Ambrogio Cesa-Bianchi, Bob Gilhooly, Gene Kindberg-Hanlon, Ben Nelson, Ivan Petrella, Greg
Thwaites, and Iain de Weymarn for help in preparing these remarks.
I. Introduction
In this era of hyperglobalisation,1 are central banks still masters of their domestic monetary
destinies? Or have they become slaves to global factors? To what extent does a global
financial cycle dominate domestic transmission mechanisms and does that, as some might
suggest, confer particular responsibilities on those central banks that most influence it?
On the surface, there's evidence of global inflationary cycles that correspond with an
intensifying globalisation that propagates common shocks via commodity, trade and financial
channels. Correlations of CPI are as elevated today as during the first oil shock and on the
surface we appear to be in the midst of a highly synchronised global rates cycle.
But as is often the case, appearances deceive. Correlations of headline CPI largely reflect
price level shocks such as those to oil (Chart 1). Core inflation rates exhibit much less
comovement but rather vary with increasingly divergent underlying economic conditions
(Chart 2).
The stance of monetary policy reflects these differences. After adjusting for unconventional
policy there's greater monetary policy divergence than implied by a simple eyeballing of the
currently highly synchronised global rates cycle. And there remains the prospect of a further
widening.
In other words, domestic economic conditions - conditions affected by domestic monetary
policy - still very much matter.
None of this diminishes the considerable challenges of returning inflation to target in the face
of global developments. There are profound secular and cyclical disinflationary forces at
work in the global economy, and for economies like the UK their impact is being reinforced
by exchange rate movements which will drag inflation down further at the policy horizon.
Moreover, as events of the past few weeks have reminded us, a variety of global factors can
affect global financial conditions and influence the neutral rate of interest.
Central banks must take these Disparate Confounding Dynamics (DCDs) into account when
setting policy.2 Even for those economies with the strongest recoveries and the best
functioning financial systems, they mean that the policy rates consistent with returning
inflation to target will likely need to rise in a gradual fashion and to a limited extent despite
robust domestic demand and firming domestic costs. For the UK at least, global DCDs
influence but do not dictate policy.
II. Developments in global inflation
The different balance of domestic and global forces across economies can be seen in the
dispersion in underlying inflation outcomes since the Great Moderation.
The Bretton Woods system collapsed with the onset of the Great Inflation. Cross-country
inflation correlations rose sharply from close to zero for much of the 1960s to about 1⁄2 in the
early 1970s as fiscal shocks were reinforced by the global oil price shock in the absence of
nominal anchors.
The eventual discovery of these anchors culminating in the widespread adoption of inflation
targeting heralded disinflation, with a high degree of co-movement of inflation throughout the
1980s and early 1990s, particularly at lower frequencies (Chart 3 - top two panels).3
By the early 2000s, inflation resembled random variations around countries' targets, and
cross-country inflation correlations fell - especially for core inflation. While the deflationary
shock of the financial crisis and the rise and fall of the commodity super-cycle have boosted
correlations of headline CPI, core inflation rates have actually become more dispersed.
This evidence of domestic monetary sovereignty is remarkable given the ever stronger
crosscountry links via commodity markets, goods and services trade, and financial channels.
While on the surface the response to the major shocks of the past decade has been a
common rates cycle (Chart 3 - bottom panel), the reality has been an unprecedented
broadening of monetary policy instruments and increased policy divergence. With the end of
additional QE, policy in the US and UK has stopped easing and there is the prospect - when
conditions warrant - of tightening. The start of normalisation is set against determined easing
of policy in the euro area and Japan as well as now across many Emerging Market
Economies including China.
III. Common linkages
Global inflation dynamics are driven by common global linkages through commodities, trade
and finance.
Commodities
The combination of the oil shock and the absence of credible monetary policy frameworks
led to high and sustained correlations of headline inflation in the 1970s. And even though the
oil intensity of production has since fallen, commodity price shocks remain an important
determinant of the global inflation landscape today.4 Energy and food prices contributed
around three percentage points to the global inflation spike at the onset of the crisis and are
currently weighing on global inflation by around 1⁄2 percentage point (Chart 4).5
However, in terms of policy credibility, the contrast with the 1970s is stark. As noted,
correlations between core inflation rates today remain low; and with credible monetary
regimes anchoring inflation expectations, policymakers can look through the one-off price
level effects of oil shocks.
In the UK, for example, despite several months of zero or mildly negative inflation rates,
there is no evidence of the development of a deflationary mindset among businesses and
households. Spending is picking up rather than being delayed. Consumer confidence is at its
highest level in over decade and retail sales have been growing at well above past average
rates. Firms' investment intensions are robust. And inflation expectations remain consistent
with our 2% target.6
Trade
Trade creates more complex global inflation dynamics. The ICT revolution has made a great
unbundling of production chains possible, and large wage differentials globally have made
doing so profitable.7 This generated vast new quantities of "supply chain trade" (Chart 5),
increasingly concentrated in Asia where, by the late 1990s, supply-chain trade had overtaken
9
that of Europe, the US and Canada.8,
All else equal, the powerful strengthening of global linkages through steadily increasing trade
has affected inflation dynamics in two ways (Chart 6).
First, imports have become much more important components of costs. Unlike commodity
shocks, changing cost pressures of intermediate goods take time to work through the supply
chains into final goods prices.10 This means that domestic monetary policy cannot focus
exclusively on domestic marginal costs, since inflation at policy-relevant horizons is
increasingly influenced by imported cost pressures.
Second, there is the possibility that increased competition from overseas might have
changed mark ups over costs and how they vary over the cycle. In other words, the slope of
the Phillips Curve may have changed.
The direction is unclear. Stronger competitive pressures might reduce the pricing power of
domestic firms, limiting their ability to change prices over the cycle and so flatten the
domestic Phillips Curve. Working in the other direction however, greater competition should
raise firms' willingness to re-set their prices, raising the slope. The balance of these effects is
an open question.11
Some prominent studies point to a flattening of Phillips curves across advanced
economies.12 For the UK, however, the evidence is less clear cut. When costs are measured
6
The average inflation expectations of professional forecasters at the two to three-year horizon is consistent
with its historical average. And measures derived from financial market prices, such as from swaps, also
remain close to historical averages.
7
Actually, this was the "second unbundling", as observed by Baldwin (2013), following the "first unbundling"
brought about by trade itself - which allowed the separation of production from consumption across time and
space. Baldwin, R (2013), "Global supply chains: why they emerged, why they matter, and where they are
going", Chapter 1 in Global Supply Chains in a Changing World, WTO.
8
See Hummels, D, Ishii, J and Yi, K-M (2001), "The nature and growth of vertical specialisation in world trade",
Journal of International Economics, 54.
9
Measured by the sum of overlapping trade as a fraction of world manufacturing trade. See Amador, J and
Cabral, S (2009), "Vertical specialization across the world: a relative measure", The North American Journal of
Economics and Finance, 20(3).
10
See Goldberg, Linda and Jose Campa (2010), "The sensitivity of the CPI to exchange rates: distribution
margins, imported inputs, and trade exposure", The Review of Economics and Statistics, 92.
11
A flatter Phillips curve has been advanced as one of the potential explanations of 'the missing disinflation' we
saw in some countries in the post-crisis period. But other factors such as an overestimate of the level of
potential supply in the economy and the hold of well-anchored inflation expectations may also have been at
work.
12
For example, see IMF (2006) "How Has Globalization Affected Inflation?, World Economic Outlook, Spring
2006, 97-134. and Borio, Claudio and Andrew Filardo, "Globalization and Inflation," Bank for International
Settlements, March 2006.
properly - adequately weighting labour and import costs - a significant change in the Phillips
curve slope is harder to detect.13
Given the importance of imports to UK inflation, accounting for around one third of the CPI
basket, the Bank of England must consider both secular and cyclical dynamics. As has been
highlighted at previous symposiums, from a secular perspective, globalisation has dampened
the relative prices of traded goods via a steady expansion in the pool of available labour. The
entry of China, India and the ex-Soviet bloc into the world economy in the 1990s effectively
and progressively doubled the global labour pool from 1.5 to 3 billion workers.14
By taking the implication of this sustained, cumulative relative price shock into account,
monetary policy has been able to deliver desired inflation outcomes. For the UK, Chart 7
shows that between 1998 to 2006, when core goods inflation averaged around -1.5%, the
stance of policy supported 3.7% average services price inflation (which was largely
determined by the evolution of domestic costs) in order to meet the inflation target.
The questions now are how soon this process of integrating a global reserve army of labour
will have run its course and whether, as services become increasingly tradable, this
balancing act between domestic and global costs will become even more complex.
Today, on top of these secular relative price trends, policymakers also have to take into
account the cyclical disinflationary impulse from the weakness in overall global demand. Cost
growth is subdued in many economies, reflecting continued slack as illustrated by the
comovement of an estimated world output gap with world core inflation - a glimpse of a "global"
Phillips curve (Chart 8).15
The impact of these forces on domestic inflation depends crucially on movements in the
exchange rate. In the face of purely nominal shocks, for example if foreign monetary policy
were excessively tight, disinflationary impulses from abroad could be expected to be
dampened by an exchange rate depreciation acting as a buffer. But today, in the UK, the
exchange rate is reinforcing disinflationary impulses from abroad, with sterling appreciating
by around 20% since early 2013.
While the appropriateness of moves of this scale in sterling and of a similar magnitude in the
dollar may be subject to debate, directionally they suggest real forces at work. One possible
driver could be the speed of adjustment of different economies to the financial crisis, with
those more flexible economies that took the more decisive action to fix their financial systems
seeing the fastest recoveries and largest appreciations.
For very open economies like the UK, with a high proportion of imports invoiced in foreign
currencies, persistent, sizeable moves in exchange rates matter for the inflation outlook.16
The pass-through of exchange rate changes through the supply chain into UK CPI inflation is
a protracted process, indicative of rich pricing frictions in the market for imported
13
See the discussion in Greenslade, J, Millard, S and Peacock, C (2008), "How has globalisation affected
inflation dynamics in the United Kingdom?", Bank of England Quarterly Bulletin, Q3. Peacock and Baumann
(2008) find evidence of a flattening of the UK Phillips Curve since the mid 1980s, conditional on treating the
UK as a closed economy. When import prices are allowed to enter firms' costs, however, the authors find no
change in the Phillips curve slope comparing 1965-2007 and 1985-2007. Peacock, C and Baumann, U (2008),
"Globalisation, import prices and inflation dynamics", Bank of England Working Paper No. 359. Groen and
Mumtaz (2008) likewise find little evidence in changes in the structural parameters of UK Phillips Curves.
Groen, JJJ and Mumtaz, H (2008), "Investigating the structural stability of the Phillips Curve relationship",
Bank of England Working Paper No. 350.
14
Source: Richard Freeman (2006), 'The Great Doubling: The Challenge of the New Global Labor Market
http://scholar.harvard.edu/freeman/publications/great-doubling-challenge-new-global-labor-market.
15
These measures weight countries by their share of UK-imports, and demonstrate the negative price pressure
facing the UK today from slack in our trading partners.
16
Gopinath, G (2015), "The International Price System", mimeo at this Symposium.
intermediate and final goods. These effects span the policy horizon, and therefore affect the
appropriate stance of monetary policy.17
In order to counterbalance the scale and persistence of exchange rate movements, UK
monetary policy needs to support a continued firming in the growth of wages and unit labour
costs. The stronger the drag from foreign cost pressures, the more domestic costs will have
to run above past averages.
Financial channels
The increased integration of the global financial system has important implications for global
and local inflation dynamics. Global financial cycles of the type described by Helene Rey at
this Symposium two years ago can amplify changes to the monetary policy transmission
mechanism through liquidity and credit creation and destruction. Financial crises and sudden
stops can spread weakness and, on balance, disinflation.
The global demand shock resulting from the global financial crisis was a dramatic and painful
example of the broader phenomenon of increasingly synchronised changes in global
financial conditions.
At the core of the global financial cycle are globally-active banks, which are key propagators
of financial conditions across borders. Looser financial conditions in banks' primary funding
markets, normally in US dollars, can encourage a build-up of leverage and translate into
increased cross-border lending and currency appreciation in the countries in receipt of the
capital flows.18
An issue at present is the possibility of these mechanisms working in reverse, perhaps in the
face of a tighter US policy stance. Capital reversals and dollar appreciation could tighten
financial conditions globally, with a knock-on impact on the balance sheets of borrowers with
20
currency mismatches.19, Some have argued that this confers a particular responsibility on
US policy makers.
Yet US policy is not the sole determinant of global rates. Many recent movements in US
long-term government bond yields have appeared to be influenced by ECB monetary policy
actions.21 This is in line with some recent evidence that funding conditions in other financial
centres, notably the UK and the euro area, affect funding conditions globally and, therefore,
the cross-border supply of funds.22
Moreover, it is the divergence of monetary policies itself rather than the stance of one central
bank in isolation that points to more volatility in exchange rates and asset markets with
associated effects on global liquidity conditions.23
17
Not surprisingly in light of its importance, issues related to pass-through are the subject of intense work at the
Bank of England.
18
Bruno and Shin (2015). "Cross-Border Banking and Global Liquidity," forthcoming in the Review of Economic
Studies.
19
Rey, Helene (2013). "Dilemma not Trilemma: The global financial cycle and monetary policy independence"
proceedings of the Federal Reserve Bank of Kansas City Economic Symposium at Jackson Hole.
20
Cesa-Bianchi, Cespedes and Rebucci (2015). "Global Liquidity, House Prices, and the Macroeconomy:
Evidence from Advanced and Emerging Economies", Journal of Money, Credit and Banking, Vol. 47, Issue
S1, No. 1.
21
See May 2015 Inflation Report. See also http://www.federalreserve.gov/newsevents/speech/fischer
20150323a.htm.
22
Cerutti, E., S. Claessens, and L. Ratnovski (2014): "Global Liquidity and Drivers of Cross-Border Bank Flows,"
IMF Working Papers 14/69, International Monetary Fund.
23
See, for example, Carney, M (2014), "The future of financial reform", speech delivered at the Monetary
Authority of Singapore.
Over the medium term, financial reform will change the nature of this cycle. Once
implemented, measures to end Too-Big-To-Fail should reduce the risk of extreme spillovers
from failures of systemically important firms. Measures such as leverage ratios, higher capital
charges on trading books, minimum haircuts for repo transactions, central clearing of
standardised derivatives should all dampen endogenous credit creation at the core of the
system and thereby limit the amplitude of the global financial cycle. Indeed, the dog that
hasn't barked in the wake of recent market turbulence has been any hint of distress at any
major financial institution.
On the other hand, while the core of the system is more secure, the system as a whole is
less able to provide on-demand liquidity. This reflects the impact of regulatory changes and
changes to market structures, including the rise of algorithmic trading and the increased
importance of asset management. Over time the Bank of England expects high liquidity
premia to persist in normal market conditions to compensate for these developments.24
The final important global financial linkage is the level of long-term risk-free interest rates
determined in global capital markets. In the medium to long term, the interest rate that
domestic policymakers must set to meet their inflation targets and keep a balance between
demand and supply is strongly influenced, through the integration of capital markets, by such
global rates.
These are the product of real global factors. For the past thirty years, a number of profound
structural changes in the world economy have pushed down on the level of world real
interest rates perhaps by as much as 450bps. Researchers at the Bank of England have
estimated a decomposition of these changes, suggesting, in declining order of importance:
slowing potential growth, the rise in saving due to demographic forces; higher credit spreads,
lower desired investment given a lower relative price of capital, changes in income
distribution; excess saving in emerging markets, and declining public investment. Collectively
these factors could account for the lion's share of the 450bp fall observed in the past
30 years and suggest that global real rates may remain low - perhaps around 1% - in the
long term.25
In the short run, the domestic real rate that balances demand and supply can deviate from
this long-term global level reflecting a range of transitory factors - including demand and
supply shocks from fiscal policy, credit markets and exchange rates. It is critical domestic
policymakers judge the scale and persistence of these factors and take them into account to
meet their domestic objectives.
For many central banks, including the Bank of England, these factors suggest that the
"equilibrium" real rate of interest - the rate needed to keep the economy at potential and
inflation on target - which was sharply negative during the crisis, will slowly rise but remain
lower than past averages for some time.
III. Concluding remarks
Recent developments in China can be assessed within this framework.
First, to the extent to which lower Chinese demand for commodities imparts a positive terms
of trade and real income shock on the UK economy, the MPC can look through the
temporary disinflationary impact on headline inflation and concentrate on potentially more
persistent effects through trade and financial channels. In that regard, a potential further
material slowing of growth in China and more broadly in non-Japan Asia, particularly if
coupled with material and persistent exchange rate depreciation, could impart further
imported disinflationary pressures over the policy horizon. In addition, a persistent tightening
of domestic financial conditions as a consequence of increased global risk aversion could
reintroduce a headwind to growth and inflation over the medium term.
These are possibilities, not certainties. Their evolution needs to be monitored, not taken for
granted. And it should be recognised that the direct exposure of the UK economy to China is
relatively modest and that the recent tightening of financial conditions comes on the heels of
a prolonged period of sustained improvement. Moreover, realisation of some of a downside
risk previously identified by the MPC, if it persists, has to be weighed against ongoing
domestic strength, underpinned by credible policy regimes and an increasingly robust
financial system. In this regard, developments in China are unlikely to change the process of
rate increases from limited and gradual to infinitesimal and inert.
Indeed, as I said recently, the prospect of sustained momentum in the UK economy and the
gradual firming of underling inflationary pressures will likely put the decision as to when to
start the process of gradual monetary policy normalisation into sharper relief around the turn
of this year. To be clear, that opinion doesn't prejudge any particular decision. But it does
indicate that recent events do not yet, to my mind, merit changing the MPC's strategy for
returning inflation to target - a strategy that already reflects the balance of two large gross
effects: namely domestic strength on the one hand and disinflationary forces from the
combination of the exchange rate and global weakness on the other.
Members of the MPC will continue to monitor a wide range of indicators of domestic
economic momentum, domestic costs, and importantly given our discussion today, the
outlook for imported disinflation (as part of core CPI inflation amongst others) in determining
the precise timing and path for Bank Rate. By doing so, we will retain our monetary
sovereignty in a globalised world.
Headline and core inflation across the world economy
Headline inflation Core inflation
Percentage change on a year earlier 15-85 percentile Percentage change on a year earlier
15-85 percentile
26
range
range
55
22
Median
Median
45
18
35
14
25
10
15
6
5
2
-5 -2
1962 1964 1967 1969 1972 1974 1977 1979 1982 1984 1987 1989 1992 1994 1997 1999 2002 2004 2007 2009 2012 2014 1962 1964 1967 1969 1972 1974 1977 1979 1982 1984 1987 1989 1992 1994 1997 1999 2002 2004 2007 2009 2012 2014
Notes: Median of year-on-year inflation across an unbalanced panel of up to 64 countries for headline inflation and up to
50 countries for core inflation. The swathes show the 15-85 percentile interval around the median. Core inflation refers to CPI
excluding energy and food.
Source: OECD, Global Financial Data, DataStream, national sources and Bank calculations.
Chart 2
International synchronisation of inflation (headline and core)
average pairwise correlation
0.6
Headline inflation Core inflation
0.5
0.4
0.3
0.2
0.1
0.0
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015
Notes: Average pairwise rolling (15 years) correlation of seasonally-adjusted quarterly headline and core inflation.
The country-specific average pairwise correlation of a time series in country i x) is the average of the
xi
(pci
contemporaneous correlation between and for all i ≠ j. The average pairwise correlation (pcx ) is computed
xi xj
x
as the average of the across all countries and, as such, provides a measure of international synchronization
pci
of xx.
Source: OECD, Global Financial Data, DataStream, National sources, and Bank Staff calculation.
International synchronisation of inflation (headline and core)
and policy rates at different frequencies
Notes. Rolling average (15 year window) of the bilateral dynamic correlations of an unbalanced
panel of 46 countries. Dynamic correlation is a function of the cross-correlation and
autocorrelation functions of two series that breaks down their comovement into different
frequencies. "Cohesion" is the average of bilateral dynamic correlations in the sample. See Croux
et al. (2001).26
Source: OECD, Global Financial Data, DataStream, National sources, and Bank Staff
calculations.
26
Croux & Mario Forni & Lucrezia Reichlin, 2001. "A Measure Of Comovement For Economic Variables: Theory
And Empirics," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 232-241, May.
Average headline and core inflation (PPP-weighted)
and the price of oil
Percentage change on a
100 7
year earlier
80
6
60
5
40
4
20
0
3
-20
2
-40
1
-60
-80 0
2005 2008 2011 2014
Global PPP-weighted core CPI inflation
Global PPP-weighted CPI inflation
Oil price (LHS, YoY)
Notes: Weighted average (with PPP-GDP weights) of headline
and core year-on-year inflation across a balanced panel of
18 countries (solid lines) and Brent Oil price (dashed line).
Source: DataStream, ONS and Bank calculations.
Chart 5
Index of participation in global supply chains
Global supply chain
80
Forward participation (2009)
index
Backward participation (2009)
70
Total participation (1995)
60
50
40
30
20
10
0
Note: The participation index adds together two components: the share of foreign value added embedded in a
country's exports (backward participation) and the share of exports made of domestic value added which is then
subsequently used by an importing country to produce their exports (forward participation). For more information
please see: http://www.oecd.org/sti/ind/global-value-chains.htm.
Source: OECD and Bank calculations.
Global imports of goods and services (% of GDP)
Per cent
Import share of GDP
35
30
25
20
15
10
5
0
1980 1984 1988 1992 1996 2000 2004 2008 2012
Note: Value of total imports of goods and services divided by
world nominal GDP.
Source: IMF World Economic Outlook database and Bank
calculations.
Chart 7
Persistent divergence in the price of (core)
goods and services
Note: Six-month average of the log-difference of core (excluding
food and energy) goods and services price indices (2005=100).
The US series uses PCE price indices and begins in 1999 due to
data limitations.
Sources: DataStream, national sources and Bank calculations.
Average world output gap and core inflation
(weighted by UK-import shares)
Percentage change
Per cent of world GDP
4 2.5
on a year earlier
3 2.3
2 2.1
1 1.9
0 1.7
-1 1.5
-2 1.3
-3 1.1
-4 0.9
2001 2003 2005 2007 2009 2011 2013 2015
Global core CPI inflation (RHS)
UK-wtd world output gap (LHS)
Notes: Average world output gap and core inflation (weighted by
UK-import shares).
Source: IMF, ONS, DataStream, and Bank calculations.