The Globalization of Inflation

In this week’s issue The Economist wonders to what degree one country’s rate of inflation is no longer determined by local forces, and instead is determined by global economic forces:

With energy and labour becoming conspicuously dearer, any inflation model based on a mark-up of prices over costs should be flashing red. Yet in the past year core inflation has not budged. How come?

Stephen Roach, chief economist of Morgan Stanley, suggests that thanks to globalisation, the inflation process has changed over the past three decades in a way that has significantly weakened the link between domestic cost pressures and inflation.

…This probably reflects two things. First, the integration into the world economy of China and other emerging economies with vast supplies of cheap labour has curbed the bargaining power of workers in developed economies. These workers therefore find it harder to secure higher wages when inflation picks up. And second, fiercer global competition has made it more difficult for firms to pass increases in wages through to prices. Instead they must absorb them in their profit margins.

…This suggests that in forecasting inflation central banks now need to pay less attention to domestic shifts in unemployment and capacity utilisation and much more to the global balance between supply and demand. The BIS’s research shows that since 1990 the core rate of inflation has become less responsive than it used to be to changes in the output gap (a measure of economic slack) in all the main developed economies except Britain. The ups and downs of inflation increasingly reflect the global balance between supply and demand.

It’s a plausible theory in some respects, but I also have my doubts about it. If it is indeed true that, due to increased global competition, firms can’t raise prices to pass along costs, then the increases in oil prices and wage rates of the past year or two should be reflected in sharply lower profit margins, as the article mentions. Yet corporate profits have grown rapidly, despite the equally rapid rise in oil prices.

While this is by no means conclusive evidence, this does seem to suggest that firms are indeed enjoying reasonably good pricing power in the face of increased input costs, despite trends in globalization.

More generally, I wonder whether there really is a big mystery about why core inflation rates have not started rising in response to higher oil prices. As I mentioned the other day, there is a simple plausible answer to the question: it may simply be the case that the labor market in the US, and demand more generally, is not strong enough to cause a wider upturn in inflation. Whether or not you believe this depends substantially on how close you think the US economy is to its potential output – a question to which there may be no clear-cut answer, as PGL has discussed.

Personally, I think that the US labor market is still fairly weak, and that demand is not particularly strong, so I think that one probably does not need to resort to the “inflation is global” hypothesis to explain why higher oil prices have not fed into broader inflationary pressures. But it’s an issue worth thinking about.