Christian Noyer: Inflation, financial innovation and monetary policies – some contemporary challenges Speech by Mr Christian Noyer, Governor of the Bank of France, at the GIC and CEPII Conference, Paris, 13 May 2008. *  *  *  Inflation pressures are now at work in most parts of the world. Today, I would like to start with offering some comments on this worrying development and then elaborate on the challenges raised by financial innovation for monetary policies. The current rise in global inflation appears in stark contrast with the price stability recorded over the past decades. During the last twenty years, globalisation has made a significant contribution to price stability. With new large players (such as China and India) entering the world economy, cheap imports of manufactured goods have become available to developed countries. The fall in import prices has allowed real consumption wages to grow without impacting real production wages. This, in turn, has lowered the inflation rate for any given level of employment. In parallel, the effects of globalisation have been felt more indirectly through increased competition, both on products and labour markets. Inflation dynamics have also changed. Maybe the most documented and commented-on of these changes has been the so-called flattening of the Phillips curve. This, in economic jargon, means that domestic inflation has become less sensitive to the domestic output gap, or, alternatively, that it has become more stable during the business cycle. There are several possible – and not mutually exclusive – explanations for this phenomenon.

Expectations may be more solidly anchored, which would lessen the impact of the output gap on current inflation. It is also possible that, as a result of structural reforms, the NAIRU has decreased in many countries in recent years, thus giving the "optical" impression of a horizontal Phillips curve during this period. In a broader sense, globalisation itself may also be responsible for the flattening of the Phillips curve. In an open economy, domestic demand changes can easily be satisfied through increased imports. As a consequence, domestic inflation may become less sensitive to the domestic output gap and more sensitive to global tensions on production capacities. Overall, these developments have made it easier for central banks to bring down inflation without real costs to the economy. But it is clear, today, that these effects are being reversed. The prices of oil, food and other commodities are now increasing fast. There might be three reasons for this rise (the importance of which is currently hotly debated): first a supplydemand imbalance; second, the emergence of commodities as an asset class, attracting substantial flows into commodity funds; and, finally, the use of commodities as a hedge against inflation or dollar depreciation. In addition, while labour supply in emerging countries will remain abundant, it is not all that clear that it will remain cheap. Indeed, we are currently seeing an increase in export prices in emerging countries, which translates into higher import prices for developed economies. In short, the world environment has become very inflationary.