The Globalisation of Inflation

The BIS has published an important working paper looking at the consequences of managing inflation given the rise of global value chains. As a result it questions the traditional approach used by central banks to attempt to manage inflation targets.  The monetary policy implications of a greater role for global factors in determining domestic inflation are farreaching, as clearly these factors are beyond the control of individual central banks. Such implications cannot be ignored.

At the heart of the globalisation of inflation (GI) hypothesis is the view that the factors influencing domestic inflation have become increasingly global. One implication of this hypothesis is that global, and not just domestic, measures of economic slack should be relevant determinants of domestic inflation and that their role should have increased with global economic integration. This more “globe-centric” view of the inflation process stands in contrast to traditional, “country-centric”, characterisations, in which a Phillips curve relates a purely domestic output gap to domestic inflation.

Because of its far-reaching implications for our understanding of inflation and the conduct of monetary policy, the GI hypothesis has attracted considerable attention.

While it is generally agreed that domestic inflation rates have been co-moving more closely, the correct interpretation of this finding hinges on the validity of the GI hypothesis. Proponents argue that tighter comovements reflect, in particular, the growing structural integration of goods and labour markets. This would, for instance, propagate national cost shocks more widely and strongly. By contrast, sceptics place greater weight on common policies. The empirical evidence so far has not yielded conclusive results.

The industrial organisation underpinning the expansion of GVCs has evolved. Initially, GVCs arose from firms’ foreign direct investment and within-firm trade across geographic borders. Growth in net international asset positions went hand-in-hand with the increase in international input-output linkages. Over time, however, outsourcing and offshoring have taken on greater prominence. Advances in technology have enabled international supply chains to expand. It is now possible to coordinate and track just-in-time production through international supply chains from start to finish, ie through all the different production stages, and by different firms located in geographically distant world regions. As a result, today’s GVCs include international manufacturing giants, such as Apple, that do not own most of the manufacturing plants in their supply chains.

These developments represent a challenge to the classical assumptions behind the traditional country-centric view of trade and inflation determination.

To assess this hypothesis, we evaluate the extent to which various proxies for GVCs explain the relative importance of global and domestic measures of slack in influencing domestic inflation. We do so in a panel setting, thereby exploring the relevance of GVCs both across countries and over time. To track the growth of GVCs, we consider total trade and its major components, focusing in particular on intermediate goods and services. To measure the influence of global and domestic slack on inflation, we rely on the published estimates of Bianchi and Civelli (2015) – estimates that are in the spirit of the analysis of Borio and Filardo (2007). That recent paper provides estimates that capture greater time variation (annual estimates for each country) and cover a wider range of countries than the earlier paper. We exclude the GFC period and its aftermath owing to the powerful balance sheet dynamics that appear to dominate the typical cyclical forces.

We find that GVCs are a key to explaining the influence of global factors on domestic inflation. There is statistically significant evidence that the growth of international input-output linkages explains the increasing sensitivity of domestic inflation to global factors. This is the case both across countries and over time. The growth of GVCs is associated with both a reduction of the impact of domestic slack on domestic inflation and an increase in that of its global counterpart. Moreover, once the role of GVCs is taken into account, we find that the conventional measure of trade openness so extensively used in the literature, based on the aggregate volume of trade in goods and services, has only limited explanatory power for the link between globalisation and domestic inflation.

Our evidence supports the view that the rise of GVCs has been a key factor behind the growing importance of the global output gap in determining domestic inflation.

We also find that controlling for the impact of GVCs, conventional measures of trade openness only have limited explanatory power. It is natural to think that a reason for this close link is the increased crossborder competition generated by the expansion of GVCs. The more easily measurable channel of this competition is through price pressures from inputs that are actually imported at all stages of the production process. The much harder-tomeasure, but possibly even more important, channel works through the inputs that could potentially be imported at the various production stages (ie through the contestability of markets for goods and services). Unfortunately, our analysis cannot distinguish between the two.20 But more detailed GVC measures based on increasingly available intermediate trade data could eventually shed further light on these channels and help refine the analysis.

Our findings point to the need for further theoretical and empirical research on the globalisation of inflation hypothesis, especially on the role of GVCs. On the theoretical side, this raises questions about approaches that model inflation as largely a country-centric phenomenon and derive the corresponding policy implications. On the empirical side, questions remain about whether it would be possible to develop more informative measures of global slack that would reflect differences in the sectoral value-added content of trade rather than simply in its economy-wide content. For example, Auer et al (2016) provide a quantification of one specific channel of interest, finding that most of the international co-movement in producer price inflation can be attributed to input-output linkages. There is also a need to extend the analysis carried out in this paper to a consideration of
alternative measures of domestic and global slack. The monetary policy implications of a greater role for global factors in determining domestic inflation would be farreaching, as clearly these factors are beyond the control of individual central banks. Such implications cannot be ignored.

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.