In recent years, one pleasant surprise in the global economy has been remarkably subdued inflation despite sharp rises in commodity prices, strong growth, and monetary policies in the major currency areas that have been broadly accommodative. Some analysts theorize that intensifying global competition has kept firms from raising prices and exerted downward pressure on wages. If so, the argument goes, continued integration of lower-cost producers in emerging market and developing countries should contain inflation for the foreseeable future. Chapter III of the IMF’s April 2006 World Economic Outlook (WEO) explores the relationship between globalization and inflation and asks whether intensifying competition can provide durable insulation from rising inflation.
The WEO finds that globalization has varying effects on advanced and emerging market economies.
In industrial economies, the direct effect of import prices on inflation has generally been small (see chart). That said, when global spare capacity has increased—as it did following the 1997–98 Asian financial crisis and during the 2001–02 global economic slowdown—declines in import prices have had sizable effects on inflation over one- to two-year periods, shaving more than 1 percentage point off actual annual inflation in some advanced economies. With low average inflation, such effects are economically significant. This lends support to the view that inflation targets should not be set too close to zero—otherwise, shocks of this size could result in periods of deflation.
Globalization has helped reduce the sensitivity of inflation to domestic capacity constraints in advanced economies. Over the past couple of decades, the prices of many items produced or consumed at home have been increasingly determined by foreign demand and supply factors. Because global economic developments have become increasingly important for domestic inflation, monetary policymakers will need to monitor these developments more closely in the years ahead.
Low non-oil import prices helped to contain inflation in the late 1990s, but that effect now seems to have run its course.
1The group of advanced economies was at the historical average rate of about 1.6 percent a year.
2Zero where no data are indicated.
Data: Eurostat, Haver Analytics, national authorities, and IMF staff estimates.
Although the impact of globalization on overall inflation has been small, its effect on prices in certain sectors, such as textiles, has been significant. In these sectors, producer prices have declined relative to the overall price level. The sectors that have become more exposed to foreign competition have seen the largest relative price declines in recent years. Globalization is not the only factor driving relative price changes, however. While openness has been important, particularly in low-tech and low-skill sectors, productivity growth has also contributed significantly to relative price changes.
Globalization has no lasting impact on inflation unless it changes the overarching objectives of monetary policy. Over the medium term, the prevailing nominal anchor—for example, the central bank’s inflation target—will determine inflation. The impact of globalization on inflation will therefore be temporary unless central banks change their inflation target. In the industrial countries, it is unlikely that globalization-related pressures on prices will lead to a lowering of inflation targets (explicit or implicit), which are already set at low single-digit levels. In emerging market and developing countries, however, there is reason to believe that greater openness has already been an important factor behind the improved policies underlying the sustained decline in inflation in recent years, and the globalization effect may have further to go.
Risk of rising inflation
Whatever restraining influence increased global competition has had on inflation over the past decade or so, the study says that monetary authorities now need to be alert to the fact that robust global growth and lessened economic slack have diminished the degree to which declining import prices have restrained inflation. With strong global growth expected to continue, the primary risk going forward is that a further upturn in import prices could result in stronger inflationary pressures, particularly in countries that are well advanced in the economic cycle. Monetary policymakers will therefore need to remain vigilant for any signs of a pickup in inflation. Globalization can no longer be relied upon to keep a lid on inflationary pressures.
Thomas Helbling, Florence Jaumotte, and Martin Sommer
IMF Research Department