Globalisation, import prices and inflation targeting Alex Bowen, Senior Policy Fellow, Bank of England Central Bank of Iceland – International Monetary Fund The Challenges of Globalisation for Small Open Economies with Independent Currencies 31 May – 1 June, Reykjavik

Globalisation is… “…a hideous word of obscure meaning…” “a movement in the direction of greater integration, as both natural and manmade barriers to international economic exchange continue to fall” (Martin Wolf (2004))

Falls in transport costs Source: OECD Economic Outlook No 81 (forthcoming)

Falls in costs of processing information Source: OECD Economic Outlook No 81 (forthcoming)

Falls in tariffs Source: OECD Economic Outlook No 81 (forthcoming)

IMF export-weighted measure of global labour supply Source: IMF

Global demand Source: Thomson Datastream Euro Area US China Non-China Asia Rest of World World Per cent Global GDP

Imports from low-cost economies Source: IMF

Central banks’ interest “the emergence of China, India, and the former communist-bloc countries implies that the greater part of the earth's population is now engaged, at least potentially, in the global economy. There are no historical antecedents for this development.” (Bernanke, 2006) “the integration of China, India and other emerging market economies into the world economy… [is] a process that has transformed supply and demand conditions across the globe.” (King, 2006)

Central banks’ interest “Have Tesco, Dixon’s and China done more to keep inflation down than the Bank economists?” (City AM, London, 21 May) “The globalisation dividend over the past decade, as cheap goods from China pushed down prices, is fading” (Daily Telegraph, London, 16 May) “China makes lots of cheap goods… the imports help keep US inflation down” (The Business, London, 21 April) “For years, British consumers… have taken for granted ‘the China effect’ – the downward pressure on inflation that comes from importing cheap goods from the workshop of the world” (The Guardian, London, 18 April)

How might globalisation affect inflation? Raising the consumption wage relative to the product wage: favourable ‘tailwinds’ –Depends on how wage bargainers respond in pay bargaining and consumption Changing short-run inflation dynamics –Product market competition –Labour market competition –Role of global vs. national indicators of slack

UK Phillips Curve Source: Bank of England

‘Globalisation and inflation in the OECD economies’ (Pain, Koske and Sollie (2006)) Imports from low-cost countries have contributed to lower domestic inflation –Direct accounting effect –Lower-cost imports have put pressure on domestic producers to lower prices in import-competing industries Domestic inflation less sensitive to measures of domestic economic slack, more sensitive to measures of foreign economic slack

Can central banks rely on China and India to do their work for them? No –Trade theory: once countries have emerged from autarky, the sign of the impact of globalisation on the terms of trade of developed countries is ambiguous –Empirics: the impact on inflation in an accounting sense may not be large, and may sometimes add to inflation –The impact on domestic inflation of an improvement in the terms of trade depends on the policy reaction

What is the impact of globalisation on the terms of trade? Consider a steady increase in the size of the industrial labour force in China Ricardian model: industrial countries’ terms of trade improve (export prices up relative to import prices) Heckscher-Ohlin model, no transport costs: impact on terms of trade cushioned by increase in labour intensity in all industries, increased specialisation ‘North-South’ models: depends on the model. In Dinopoulos and Segerstrom (2006), for example, the North’s terms of trade deteriorate as the Southern labour force increases Exhaustible natural resource pricing: impact on expected future path of demand and real interest rates important; price increases not due only to short-run supply constraints

Emerging market economies’ contribution to world consumption of commodities ( ) ‘Leading EMEs’ = China, Brazil, India, Mexico and Russia

UK terms of trade Source ONS

Price levels for UK manufacturing goods imports Source: ONS and Bank of England

Annual import price inflation Source: ONS and Bank of England

‘Has globalisation changed inflation?’ (Ball (2006), NBER WP 12687) ‘Has globalization reduced the long-run level of inflation?’ ‘Has it affected the structure of inflation dynamics, as summarized by the Phillips Curve?’ ‘Has it contributed substantial negative shocks to the inflation process?’

‘Has globalisation changed inflation?’ (Ball (2006), NBER WP 12687) ‘Has globalization reduced the long-run level of inflation?’ No ‘Has it affected the structure of inflation dynamics, as summarized by the Phillips Curve?’ No ‘Has it contributed substantial negative shocks to the inflation process?’ No

Inflation in industrial countries Q1 1962Q1 1972Q1 1982Q1 1992Q United Kingdom per cent Source: Bank of England

Goods and services inflation Source: ONS

Conclusions Globalisation a hugely important phenomenon… …but not primarily a monetary one It could have a significant impact on short-run inflation dynamics in developed open economies… …but the evidence is not clear-cut Monetary policy, not relative import prices, is the key determinant of domestic inflation

Further work needed Defining terms: what is globalisation? Integrating trade theory and open-economy macroeconomics better What determines emerging-market export prices? Estimation and testing of structural models of inflation with an explicit foreign sector and policy function