For years, globalization was touted as the undisputed good news in terms of the low prices it delivered to consumers. It was unqualified bad news only if you happened to be the fellow who made the goods now being produced in China.
Now the tide has turned. After more than a decade of “exporting” deflation, China has gone over to the dark side, according to the US government statistics. The price of Chinese imports to the US has risen in the last few months, triggering predictable reactions based on faulty assumptions.
Specifically, the question is, can one country import inflation from another? In the case of China and the US, it depends on whether one is flying from east to west or west to east. China pegs its currency to the US dollar. In other words, it has adopted US monetary policy as its own. If the US inflates, China inflates, not the other way around.
JPMorgan Chase & Co. senior US economist Jim Glassman says, “If China had an independent monetary policy and its currency wasn’t linked, rising prices would be offset by a falling currency and the US wouldn’t see any effect.
The broader issue is whether a sovereign nation with an independent central bank can import inflation—or deflation—from overseas. The answer is, it depends on what the monetary authority in the importing country does. A sovereign central bank isn’t a “price taker,” or an inflation accepter. Instead, it always has the ability to offset any relative price change, be it in domestic or foreign goods, with tighter monetary policy.
Forget about borders and exchange rates for a moment and think about individual prices in the domestic economy. Let’s say the price of oil goes up because demand increases. Is that inflationary? Former Federal Reserve chairman Alan Greenspan used to explain to Congress that relative price changes are not inflationary per se. That is as true for the price of oil as it is for the price of labour (wages), although you’d never know it from listening to policymakers.
For a given stock of money, a rise in the price of oil may translate into a one-time rise in the price level. With time, the price of something else will fall as consumers cut back on non-oil purchases. The same is true for the price of imports. If consumers have to pay more for items made in China, they will have less money to spend on domestic goods and services and other foreign imports—unless the central bank accommodates those higher prices by allowing the money supply to increase. So it is always and everywhere the province of the central bank to determine its domestic inflation rate.
Fed governor Don Kohn and San Francisco Fed president Janet Yellen have challenged the notion that central banks have to passively accept whatever price increases are thrust on them from abroad.
“In the end, however, policymakers here and abroad cannot lose sight of a fundamental truth: In a world of separate currencies that can fluctuate against each other over time, each country’s central bank determines its inflation rate,” Kohn said in a speech to the Boston Fed’s 51st economic conference in Chatham, Massachusetts, on 16 June 2006. While it’s too early to assess the inflation implications of the increased integration of goods and markets, “it is also clear that such developments do not relieve central banks of their responsibility for maintaining price and economic stability,” Kohn said.
Here, here. Another decade of globalization won’t change the basic reality either. “With respect to monetary policy, I find nothing either in theory or the existing empirical evidence to overturn the conclusion that a country like the US, operating under a flexible exchange rate regime, can ultimately achieve the inflation target of its choice,” Yellen had said in a May 2006 speech at a conference on the euro and the dollar in a globalized economy at the University of California at Santa Cruz.
The departure point for some recent studies on the role of globalization is the low and stable inflation globally accompanying increased economic integration. A recent working paper by economists Claudio Borio and Andrew Filardo at the Bank of International Settlements in Basel, Switzerland, concedes that better monetary policy, with central banks around the world adopting implicit or explicit inflation targets, explains the improved performance.
Still, they found some “prima facie evidence” of the role of “global slack” in national inflation, leading them to question the “near-term effectiveness of domestic policy levers.” (If you think the output gap is a slippery concept, try measuring global capacity.) To the extent that domestic inflation is increasingly influenced by “global capacity constraints, this could weaken the near-term efficacy of monetary policy levers because of their limited (i.e. domestic) reach,” they said.
If “globalization” and “common external shocks” are the main contributors to inflation, not common monetary policies, “this would imply that national central banks’ ability to steer domestic inflation has been severely reduced,” said Joachim Fels, chief fixed-income economist at Morgan Stanley in London, in an email response to my question. As long as globalization doesn’t mean one world central bank, “flexible exchange rates give countries the independence to set their own inflation goals,” Glassman says. “That insulates everyone else from what you choose to do.”
And as for price shocks, the central bank has the ability to offset them, whether they occur at home or abroad. Inflation isn’t transmitted via spores in the air. It’s a monetary phenomenon, and as such, starts and ends on native shores.
Globalization hasn’t made central banks impotent. To the contrary, their unity of purpose in the goal of price stability has made them more powerful.
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