Bernanke: Globalization May Have Increased Inflation

Continuing with the post below this one... Recently, it was reported that the relationship between changes in the real economy and changes in the inflation rate is lower than it used to be, something discussed here. Below, Federal Reserve Chairman Ben Bernanke is reported as saying he agrees with these findings:

The relationship between slack in the economy and lower inflation is ''clearly lower'' than it used to be.

Another aspect of the recent debate over monetary policy concerns how globalization has affected inflation, and the Fed's ability to affect inflation through monetary policy. Here's Chairman Bernanke's view, a view that agrees with what I've been arguing:

Bernanke Says Globalization May Boost U.S. Inflation, Reuters: Global factors may on balance have boosted U.S. inflation, but globalization has not affected the ability of the Federal Reserve to influence U.S. financial conditions, Fed Chairman Ben Bernanke said on Friday.

''When the offsetting effects of globalization on the prices of manufactured imports and on energy and commodity prices are considered together, there seems to be little basis for concluding that globalization overall has significantly reduced inflation in the United States in recent years; indeed the opposite may be true,'' he said in a speech at Stanford University. ...

The central bank chief said the Fed finds it difficult to pin down a fixed number for any natural rate of unemployment. ''There are a couple of problems that have emerged with using a fixed number like that for analyzing the macro-economy,'' he said.

The relationship between slack in the economy and lower inflation is ''clearly lower'' than it used to be, Bernanke said.

Bernanke said that globalization has not ''materially affected the ability'' of the Fed to influence U.S. financial conditions, ''nor has it led to significant changes in the process which determines the U.S. inflation rate.''

Overall, globalization has probably spurred inflation in the United States rather than lowered it because recent increases in energy and commodity use in developing countries such as China and India have pushed up prices for such goods, Bernanke said.

He noted a study that found that if the share of world trade and economic growth of non-industrial countries remained at its 2000 level, oil prices would have been as much as 40 percent lower in 2005 and metals prices as much as 10 percent lower.

''Accordingly, in the past several years, the effect of growth in developing economies on commodity prices has been a source of upward pressure on inflation in the United States and other industrial economies,'' he said.

At the same time, increased trade with China and other developing countries has led to slower growth in the prices of imported manufactured goods, Bernanke said.

He cited a study concluding that trade with China alone reduced annual import price inflation in the United States by about 1 percentage point over 1993-2002.

The Fed is devoting more resources and time to trying to understand the effect of increased global integration on inflation and the central bank's ability to maintain price stability and ensure low unemployment, Bernanke said. ...

Update: Here is the speech, "Globalization and Monetary Policy."

Update 2: Here are a few quotes from the speech at Stanford with some of the discussion of the supporting research, e.g. the work on the "global output gap hypothesis" that is part of the recent discussion about the changing relationship between domestic real activity and inflation. One reason we ,ight see a declining relationship between the output gap and inflation is that the relevant concept of the output gap has changed while our measurement of the gap - domestic output minus domestic potential output (which is shaky in any case) - has not. Thus, it is not that the output gap and inflation are unrelated, i.e. that the Phillips curve is dead, but rather the appropriate definition of the gap to use in assessing the relationship has changed. There are quite a few more references and a lot more discussion in the speech itself:

The empirical literature supports the view that U.S. monetary policy retains its ability to influence longer-term rates and other asset prices. Indeed, research on U.S. bond yields across the whole spectrum of maturities finds that all yields respond significantly to unanticipated changes in the Fed’s short-term interest-rate target and that the size and pattern of these responses has not changed much over time (Kuttner, 2001; Andersen and others, 2005; and Faust and others, 2006). Empirical studies also find that U.S. monetary policy actions retain a powerful effect on domestic stock prices.

...

I draw two conclusions... First, the globalization of financial markets has not materially reduced the ability of the Federal Reserve to influence financial conditions in the United States. But, second, globalization has added a dimension of complexity to the analysis of financial conditions and their determinants, which monetary policy makers must take into account.

...

International factors might affect domestic inflation through several related channels. First, the expansion of trade may cause domestic inflation to depend to a greater extent on the prices of imported goods--not only because imported goods enter the consumer basket or (in the case of imported intermediate goods) affect the costs of domestic production, but because competition with imports affects the pricing power of domestic producers. Second, competitive pressures engendered by globalization could affect the inflation process by increasing productivity growth, thereby reducing costs, or by reducing markups. Third, to the extent that some prices are set in internationally integrated markets, pressures on resource utilization in foreign economies could be relevant to domestic inflation.

Some analysts might object to the proposition that globalization affects the inflation process at all on the grounds that the structural changes that globalization engenders can affect only the relative prices of goods and services; in contrast, inflation--the rate of change of the overall price level--must ultimately be determined solely by monetary policy (Ball, 2006). Certainly, monetary policy determines inflation in the long run, and the central bank must take responsibility for the inflation outcomes generated by its policies. ...

However, the conclusion that inflation is determined only by monetary policy choices need not hold in the short-to-medium run.

...

In a globalized economy, the level of resource utilization in the world economy is another potential influence on domestic inflation. Standard analyses of inflation based on the concept of a Phillips curve assign a role in inflation determination to the domestic output gap--the difference between the economy’s potential output and its actual production. According to this theory, the existence of slack in the economy makes it more difficult for producers to raise prices and for workers to win higher wages, with the result that inflation slows. These conventional analyses have considered only the possible link between domestic inflation and the domestic output gap. But in an increasingly integrated world economy, one may well ask whether a global output gap can be meaningfully defined and measured and, if it can, whether it affects domestic inflation. In other words, all else being equal, would a booming world economy increase the potential for inflationary pressures within the United States?

In principle, with the domestic determinants of inflation held constant, reduced slack in the global economy could increase domestic inflation for a time if it led to higher prices for some traded goods and services relative to the prices of goods and services that are not usually traded. For example, suppose that the United States produces personal computers both for export and for domestic use, and that more-rapid growth abroad increases the world demand for computers. Stronger global demand for computers raises the prices that U.S. producers can charge their foreign customers. Moreover, because all computer producers are facing a stronger global market, U.S. producers can charge more for their output at home as well. If producers of many goods face increases in worldwide demand, the net effect could be higher inflation in the United States, even though there may be no measurable effect on the prices of U.S. imports.

The idea is intriguing but again, unfortunately, the evidence is so far inconclusive. Early work, including some done at the Federal Reserve Bank of Boston, found no effect of global demand conditions on U.S. inflation, as did most of the subsequent research. Recently, however, several researchers affiliated with the Bank for International Settlements (BIS) have reported results favorable to the global output gap hypothesis (Borio and Filardo, 2006).

Comments

[Winslow R.]

"In analogous fashion, the Fed’s ability to influence real interest rates at shorter horizons provides a lever for affecting longer-term real yields. Like nominal long-term yields, real long-term yields can be viewed as an average of current and future expected short-term real rates, so that the effects of monetary policy on shorter-term real yields feed into longer-term yields as well."

Bernanke is just wrong on this, well.... 1/2 wrong.

Expectations of future Fed policy provides a 'lever' that only works to bring rates down, intermediators borrow short and lend long.

To raise long-term rates requires expectations of future Fed inaction in the face of high government deficit spending, something the BOJ has spectacularly failed to allow.

Why?

[Movie Guy]

Mark Thoma and Ben Bernanke raise an interesting point regarding the potential for inflation.

Any substantial global economic growth can put upward pressure on material inputs (raw materials, agricultural products, component shortages or bottlenecks), but the offset of manufacturing and services offshoring and consolidation of such offshoring by developed nations to production locations in developing nations rein in a considerable amount of potential inflation. Inflation could have been higher and more widespread had not the production factor changes occurred.

Raw material inputs for energy, power generation, and mobility platforms (vehicles and other forms of transportation) will likely continue to reflect higher prices based on increasing global demand absent a better global mix of alternate sources of energy and power, or increased discoveries and mining of such raw materials (crude oil, natural gas, methane and other energy sources).

There is limited likelihood of a lack of production capacity to satisfy global demand of goods and services based on FDI incentives and developing nations' domestic capacity growth trends based on global demand requirements and existing WTO policies and WTO membership agreements (GATT and GATS driven). Absent specific shortages in the material inputs or temporary component bottlenecks, there should no likelihood of significant inflation driven primarily by the production of goods based on the current trend of offshoring by developed nations. A number of offshoring nations' sources of potential production remain untapped.

On balance in the near term, the primary sources of inflation concerns should be material input shortages or energy and fuel shortages until such time as alternative sources are employed.

[Movie Guy]

Offshore inflation? Reasonably unlikely absent a major natural disaster, medical crisis, or economic event.

Regarding offshoring and consolidation of production sourcing, I recomment this explanation:

Economic Hydrology Theory

The Future of U.S. Domestic Production versus Offshore In-House and Offshore Outsource Production of Goods and Services

Once the WTO and national governments improved the opportunities for corporations to invest in the least expensive global production locations, the stage was set. Coupled with continually improving transportation and communications efficiencies, the successes of offshoring and outsourcing corporations which led the way were met by competitive desires of other corporations to also seek new lowest cost production sources. At present, over 450 of 500 top U.S. corporations have operations in China, as an example.

Unimpeded and with regard to available skill levels and technologies, corporations will seek out the lowest cost blue collar and white collar production sources on the planet and will create new production empires in those locations as fit their market needs. Currency manipulations and other foreign and domestic government incentives that improve foreign-based blue collar and white collar production opportunities increase the rate of flow or transference to such locations.

The larger concentration of global production in lowest cost production environments results in a convergence of foreign direct investment (FDI) monies targeted toward achieving greater scales of production at these locations. This effort, in turn, minimizes the need for investment and development elsewhere by such corporations which further eliminates the logistical and technical support chains that previously existed for duplicate operations at facility locations in other nations. The results are reduced overall investment costs, reduced production costs, labor substitution, and reduction of related supporting logistical and technical support services and employment in other nations.

This is what I call the Economic Hydrology Theory.

Like water seeking the lowest geographic point due to the forces of gravity and available terrain features, corporations likewise seek the lowest (least expensive) and most efficient production cost environments on a global basis that meet their domestic and international market needs. The transnational corporations have not migrated to China and India by accident or through illogical business decisions. The trade tariffs (or dam gates) have been pulled down much lower and the corporate production flowed out of the U.S. as a result. The finished goods and services come back via efficient transportation and communication technology means, but the production cost savings are so great that returning such operations to the U.S. is generally out of the question at this time. This is the bottom line of Economic Hydrology Theory.

The likelihood of higher levels of inflation growth over previous sources of domestic developed nation production as exhibited by the current sources of offshoring source production approach is minimal.

[anne]

Ben Bernanke must avoid controversy but that may slant research. Along with arguing that increased international trade has lowered costs, there is the argument that international development has raised energy and commodity prices and mildly accentuated inflation. However, Joseph Stiglitz argues that energy price increases in particular can be attributed to the war in Iraq and I would intuitively agree. At least we are sure that energy prices rose through the building to the attack on Iraq and since the occupation.

[anne]

War in Iraq was supposed by many analysts to have a short term raising effect on oil prices, and a long term lowering effect as Iraq's oil flowed. Iraq was supposed to be re-built with Iraq oil revenue. But, the short term effect of oil price increases has been 5 years and we think nothing of warning and warning Iran and any link to oil prices. How much of the energy price increase we have experienced is related to the needless tragic war in and occupation of Iraq?

[ken melvin]

Stock markets prices (controlled by speculation, and/or mutual funds) indirectly produce most of today's inflation. Speculation drives prices up, earnings must be maintained, voila - price to the consumer goes up since there is no other (other China) to increase profitability.

[spencer]

You are usually such a good writer that sloppy thinking seldom shows up here. But this time you started this post with a misstatement that falls right into the Kudlow-Laffer trap.

You started out saying:that the relationship between changes in the real economy and changes in the inflation rate is lower than it used to be. This implies that you think that growth causes inflation. Later you corrected yourself to state that tight capacity utilization causes prices to rise.

Kudlow-Laffer love every example they can get to claim that "liberals" and/or mainstream economists believe that growth causes inflation. So do not be surprised to find one of them quoting you soon to prove their point.

[voltaire]

Bernanke's comments leave me troubled for the reason that they contradicts all recent evidence that globalization, has indeed, decreased price inflation over the past quarter century. Plot the growth in international trade over core CPI and the near perfect inverse relationship to lower or stable CPI is evident. The logic is simple: given a strong currency (USD)and constantly cheaper imports, from 8% annual foreign labor productivity, domestic prices on all tradable goods and services have capped domestic prices as well as tradable goods wages, which in turn has kept a cap on nontradable goods and services prices and wages. True, global demand has increased the prices of commodities, but since raw materials are only 20% of the cost of the finished good the net effect, offset by exceptionally high foreign productivity, results in lower import prices.
Foreign import prices, ex oil, have almost consistently been under the core CPI. Also strange would the implied Rx: if one assumes globalization causes higher inflation...less globalization as helping monetary policy, is Bernanke giving support to the protectionist camp, strange, very, very strange.

[cm]

So, inflation is caused by China, not US profligacy and financial speculation.

[paine]

paine says...

great stuff mark

gentle ben reviewing his control panel
however only raises higher the questionsin non specialists minds
the minds he's attempting to put at ease

i can here somwe one saying

"gee there's i didn't know
there was some question
about the causal link between
short term policy rates
and longer term market rates"

or

"wow...so the globalization
of our industrial supply lines
can cut both ways
raise and lower inflation..."

or

" how can you talk about a natural rate of unemployment
if the production gap and employment pool is global"

[wjd123]

I put together my own test for inflation. :-)

Looking at inflation through the criterion of actual purchasing power my indicators shows the following:

Wages in the developing world are rising; that's a plus inflation indicator.
Wages in the United States are falling; that's a minus inflation indicator.

Increased production is causing commodity prices to rise and along with them the price of goods; that's a minus inflation indicator in both worlds. (Remember the criterion we are using is purchasing power.)

Debt ceilings in the United States have been reached; that is a minus inflation indicator.

Saving in developing countries are being maintained; that's a minus inflation indicator.

Rents are rising in developing countries; that's a minus inflation indicator.
Rents are falling in the United States; that's a plus inflation indicator.

Interests rates are rising in the United States and the developing world; that's a minus inflation indicator.

After adding up the plus and minuses for labor, land, and capital effecting purchasing power in five categories for the United States and the developing world, I come up with four minuses for the United States and the developing world and one plus for both.

So based on the purchasing power of consumers, inflation is well in hand. It's recession we should be worried about.

[kotika]

International trade lowers prices, argued Adam Smith. There is nothing new under the sun, and his arguments for free trade still stand. But it is also clear that the increases in energy and metal prices have to do with the growth of developing countries, or globalization - however you wish to label it.

What gives? Well Adam Smith argued also that the long term trend in the value of commodities is down. His prediction has been borne out in the nearly three hundred years since. The point is, and clearly explained in the Wealth of Nations, that any temporary increase due to some new industrial demand brings out previously unimaginable improvements in technology of mining, producing and delivering those commodities so that the end result of any large increase in the demand of any commodity is a corresponding decrease of its cost.

Look it up - the real cost of any and every commodity and industrial age product and has been going down for centuries. If you think that's an oxymoron, i can tell you what has increased in real price - human labor. And this concerns not only the Doctor and the Lawyer but also the manual laborer in every country. This is also why the Fed watches productivity, if wages go up without being able to produce more in the same amount of time that would lead to inflation. And low and behold, the long term real productivity growth is positive, somewhere around 3-4%, which means that the real price of goods as measured in terms of human labor should halve every 20-30 years.

I have talked mostly of the real phenomena above, i think nothing i said prevents inflation from being positive or even large, that is the job of the Fed in controlling monetary conditions. They should stick to it, and not bother too much about the real economic phenomena. This is in part what Bernanke and others are saying, that growth which is a real phenomenon appears to have decoupled from the monetary phenomenon of inflation.

[Martin]

Mark,

Globalisation = more people dipping into a common pool of commodities = price rises = inflation.

Regardless of whether or not you define 'globalistion' as the mystical and mythical 'tide that lifts all boats' beloved by the more economistic libertarians or use Stephen Roach's (more accurate) definition of it as 'global labour arbitrage', the outcome is the same.