Globalisation and its implications for inflation in advanced economies

Prepared by Maria Grazia Attinasi and Mirco Balatti

Published as part of the ECB Economic Bulletin, Issue 4/2021.

1 Introduction

The globalisation of inflation hypothesis argues that the factors influencing inflation dynamics are becoming increasingly global. In recent years, economists have started to reassess the predictive power of standard inflation models (e.g. the Phillips curve) and to increasingly look at global factors, including globalisation, as a possible explanation behind the reduced sensitivity of inflation to domestic determinants (the so-called globalisation of inflation hypothesis).^[1] Accordingly, in addition to domestic measures of slack, standard models of inflation should account for the role of global factors over and beyond their impact via import prices.

The interest in the global determinants of inflation stems from the observed co-movement of inflation rates across advanced economies (AEs) amid the growing internationalisation of goods, services and financial markets. Average headline inflation rates in AEs have declined from around 10% in the 1970s to rates below 2% since 2014. However, the pace of globalisation has accelerated significantly since the early 1990s (Chart 1) with profound implications for the structure of the global economy. While the role of external factors (e.g. commodity prices) on inflation outcomes has been widely documented, it could also be argued that globalisation, by increasing the interconnectedness of the world economies, entails the propagation of shocks in one economy to other countries, thus influencing domestic macroeconomic outcomes. In this regard researchers have looked at the possibility that globalisation might affect inflation in a more fundamental way rather than just causing temporary shifts in the level of inflation.^[2] More specifically, by changing the structure of the world economy, globalisation could alter the inflation formation process thus affecting the more persistent component of inflation across AEs.

This article reviews recent inflation developments across AEs and the channels through which globalisation can feed into the more persistent component of inflation. The question is relevant from a monetary policy perspective. If the impact of globalisation on inflation is found to be only transitory, then the monetary authority should “look through” it. If, instead, globalisation entails a change in price and wage-setting behaviour, it would feed into the more persistent component of inflation, with direct implications for the conduct of monetary policy. The focus of this article is on medium-term inflation developments, measured as a smoothed average of core inflation in order to exclude the more volatile sub-components (such as oil and food prices) and referred to as the more persistent component of inflation. The article finds that three elements of globalisation appear to be linked to a lower persistent inflation: trade integration, informational globalisation and global value chain participation. However, available estimates suggest that this effect is economically small, and the article concludes that globalisation does not appear to be a key determinant of the synchronisation and decline in inflation rates observed across AEs. Looking ahead a reversal (or further slowdown) of globalisation trends could provide only limited tailwinds for inflation trends.

2 Inflation in advanced economies: historical developments and common drivers

Cyclical shocks may cause temporary deviations of inflation from the central bank’s objective. In the pursuit of their price stability mandate, central banks aim at a low and stable rate of inflation over the medium to long term. This amounts to setting a quantitative target (or objective) for the annual rate of change in the price level, which usually corresponds to 2%.^[3] As headline inflation comprises a broad-based basket of goods and services, movements in the more volatile inflation components, such as commodity and food prices, influence inflation temporarily. These short-term changes are usually looked through by the monetary authority,^[4] which relies on measures of underlying inflation to have a more accurate signal of medium-term inflationary pressures.^[5]

Inflation outcomes may also be influenced by structural forces reflecting, for example, changes in the structure of the economy stemming from both domestic and external factors (e.g. increasing trade integration). Given their gradual and persistent character, these changes could feed into the more persistent component of inflation thus potentially interfering with the medium-term price stability objective. Central banks would then tend to react in order to insulate inflation outcomes from this type of perturbation. However, since in recent years interest rates have been nearing the lower bound in many countries, a fundamental consideration, which is outside the scope of this article, is whether the monetary policy space available to neutralise the persistent influence of structural forces on inflation is diminished.

Over the past half-century, average inflation rates across AEs have displayed increasing co-movement amid declining volatility. Since the early 1970s and until the mid-1980s, inflation rates in several AEs rose to levels exceeding 10% (Chart 2), with the exception of Germany and Switzerland.^[6] Inflation rates started to decline and to stabilise at lower levels in the late 1980s amid a shift in several central banks towards a more aggressive monetary policy stance. Since the early 1990s both the headline and the more persistent component of inflation started to decline gradually, along with reduced dispersion across AEs (Chart 2). In the decade after the global financial crisis (GFC), inflation rates have been trending further down along with a marked decline in volatility. During this period, characterised by low inflation and low interest rates, economists and policymakers have been confronted with a “missing inflation” puzzle.

The increasing synchronisation of inflation rates across countries reflects the influence of common factors, as widely documented in the literature. Ciccarelli and Mojon^[7] document the large co-movement in headline inflation rates in OECD countries and show that global inflation accounts for about 70% of the cross-country variance of inflation. The authors find that the inclusion of global inflation consistently improves domestic inflation forecasts. In a similar vein, Mumtaz and Surico^[8] find that the importance of the global factor was more prominent until the mid-1970s, while it declined thereafter.^[9]

International inflation co-movements may be explained by factors such as common shocks, the evolution of the monetary policy regime and structural changes. These factors affect inflation outcomes in different ways with different implications from a monetary policy perspective.

First, common shocks, of which fluctuations in oil and non-oil commodity prices are a typical example, are a global source of headline inflation volatility. As argued by Lane,^[10] since central banks tend to stabilise medium-term inflation without fully insulating inflation outcomes from the impact of these (largely temporary) shocks, the latter may account for strong co-movements in the deviation of national inflation rates from their medium-term target (or objective). Chart 3 depicts the evolution of the estimated (unobserved) common factor in headline inflation across countries and the estimated contribution of oil prices since the early 1970s. The chart illustrates that fluctuations in oil prices played a significant role in explaining the international co-movement in inflation during the 1970s, but since the late 1980s their importance started to diminish thus pointing to a role also for other factors.^[11]

Second, the shift to inflation-targeting regimes played an important role in the convergence of inflation outcomes towards low and stable levels across AEs. The early 1990s marked a shift in the monetary policy conduct of several AE central banks towards an inflation-targeting regime aimed at taming persistently high inflation rates and anchoring inflation expectations (Table 1).^[12] The pursuit of low and stable inflation benefited from a higher level of central bank independence as the consensus around a reduction of political pressure in the conduct of monetary policy emerged.^[13] The successful taming of inflation under inflation-targeting frameworks until 2007 was tested by the GFC.^[14] Inflation rates remained subdued and interest rates approached the effective lower bound (Chart 4) thereby constraining the available monetary policy space to bring inflation back to target.

Third, structural changes in the economy can influence inflation dynamics by feeding into the more persistent component of inflation. The structure of the economy matters for inflation outcomes because it determines price and wage-setting dynamics. Changes in the structure of the economy fall broadly into two main categories.^[15] First, changes that are domestic in nature but affect national economies in similar ways, thus resulting in a common inflation pattern across countries. Demographic changes are one example of this type of structural change and may influence inflation through multiple channels.^[16] Second, changes of a global nature that increase the interdependence of the world economies, of which the economic and financial globalisation that has taken hold since the 1990s is certainly the most notable example.

The influence of globalisation on inflation outcomes has been widely debated by policymakers and academics alike. In a standard Phillips curve framework,^[17] external forces (e.g. foreign demand, foreign prices) feed on inflation via pressures on domestic slack and/or via import prices of final goods or intermediate goods. Moreover, as trade integration mainly influences the price of tradable goods relative to non-tradable goods the impact on average inflation rates over the medium term is thought to be limited. Arguments in support of a more direct role of foreign factors in explaining inflation fluctuations have been growing,^[18] calling to augment traditional Phillips curve models with measures of global slack. At the same time, the transformational role of globalisation for the world economy has been increasingly acknowledged. Global economic integration in its various dimensions (e.g. labour, trade in final and intermediate products) may act as a persistent and positive supply shock leading to sustained disinflationary pressures, thus shifting the Phillips curve downwards. But it may also affect the market structure by increasing competition within many markets, thus causing structural changes that would influence the inflation process, possibly flattening the Phillips curve.^[19]

3 Globalisation: main features and transmission channels to inflation

Globalisation, in its multidimensional character, has shaped the world economy in a fundamental way. Albeit on an upward trend since the 1970s, globalisation gathered speed in the 1990s, entering a period of “hyper-globalisation”^[20] which led to the progressive reduction of (cross-border) frictions to the flow of people, capital, goods, services, information and knowledge. Globalisation stalled after the GFC owing to a slowdown in the speed of economic integration. This slowdown reflected compositional effects stemming from the increasing weight of emerging market economies (EMEs) in global economic activity, as these economies have a lower trade intensity; a moderation in global value chain (GVC) expansion which partly pre-dated the GFC; and diminishing support from trade finance.^[21]

Trade integration and the increasing fragmentation of production in vertically integrated supply chains have been a landmark feature of globalisation. Trade intensity, measured as the share of world imports of goods and services to GDP, has increased from 30% in 1980 to more than 50% in 2008 and has broadly stabilised around this level since. Trade integration was spurred by the trade liberalisation efforts (i.e. bilateral and multilateral free trade agreements) which resulted in an unprecedented decline in average tariff rates (Chart 5, panel a)) as well as lower taxes and regulations. At the same time, advances in information and transportation technologies and falling trade barriers enabled the fragmentation of production processes along supply chains (GVCs) located in different countries. GVC integration resulted in a sharp increase in trade in intermediate goods which are used as inputs of production. From 1995 to 2007, GVC-related trade rose from around 25% to 40% of global exports and plateaued since the GFC (Chart 5, panel b), red line).^[22] The increase in GVC participation is closely linked to the growing integration of EMEs in global production processes, particularly the unprecedented rise of China whose share in global GDP has increased from about 5% in 1993 to 19% in 2019.

Trade globalisation may affect inflation in AEs by influencing the price and wage-setting mechanism. Increasing trade integration and greater participation of low-cost producers in global production has a direct disinflationary effect. This effect works via lower imported inflation,^[23] but also via decreasing the average mark-ups of domestic firms in the face of tougher foreign competition.^[24] As a result, less productive firms could exit the market, further lowering cost pressures.^[25] Participation in GVCs can further contribute to the disinflationary effects, and it is associated with more synchronised inflation dynamics across AEs.^[26] Andrews et al.^[27] find that for AEs the rise in GVC participation has pushed producer price index (PPI) inflation down by 0.15 percentage points on average. GVC participation contributes to lower inflation by exerting downward pressures on unit labour costs (by raising productivity and reducing wage growth) in the importing country, especially when low-wage countries are integrated in supply chains.

Globalisation has also had pervasive effects on labour markets ‒ eroding the bargaining power of workers in AEs and further moderating production costs. On the one hand, increased trade integration has enabled a geographical shift of the centres of production towards large EMEs characterised by an abundance of low-cost labour for manufacturing goods. In this regard notable examples are the re-integration of central, eastern and south-eastern European countries into the market economy after 1990 and the integration of China in the world economy in the early 2000s, which both constituted an unprecedented increase in global labour supply. Many workers moved within countries from rural areas to cities. In China, for example, the trend in rural to urban migration is closely linked to this integration and has allowed for a decades-long expansion of export capacity without a concomitant increase in the cost of production.^[28] On the other hand, by facilitating international migration flows towards AEs, globalisation has influenced the relationship between unemployment and the wage-setting behaviour of the hosting country. In the presence of a strong rise in migration inflows, heterogeneous labour supply elasticities between native and immigrant workers lower the marginal labour costs and put downward pressure on inflation.^[29]

Informational globalisation and digitalisation are two other dimensions of global integration which have been increasing across AEs since 1990. The technological advancements of the last decades have led to a sharp increase in the flow of information and communication across AEs. While these flows are very difficult to measure, the KOF Swiss Economic Institute produces some indicators.^[30] The KOF Informational Globalisation (de jure) Index^[31] refers to the ability to share information across countries and is measured by internet access and press freedom. While this measure has been trending upward since 1970, the de facto dimension of the KOF Informational Globalisation Index, measured by used internet bandwidth, international patents and technology export increased strikingly after the GFC. Both measures have plateaued in the last few years.

Digitalisation-driven integration has changed the pricing behaviour of large retailers at a global scale. The advent of algorithmic pricing technologies, easily transferable across countries and firms, and the transparency of the internet have enlarged geographical horizons for consumers, and reinforced globalisation trends via lower search costs for consumers and improved efficiency and productivity for producers. The enhanced competitive behaviour of firms increases the geographical correlation of price changes and tends to dampen price increases.^[32] Firms in some industries update their prices more frequently than in previous decades, although the extent to which dynamic pricing affects the flexibility of reference prices, hence the slope of the Phillips curve, remains unclear. For the United States there is evidence that goods prices have become significantly more uniform across retailers, suggesting higher strategic complementarities in the price-setting behaviour of firms (i.e. a high sensitivity to competitors’ prices)^[33] whereas for some euro area countries early evidence points to less uniform pricing than in the United States.

The rise of “superstar firms”, many of which operate in the technology sector, has an ambiguous impact on price setting. Highly productive “superstar firms” have rapidly increased their market share, allowing firms with superior quality products, lower marginal costs or greater innovation ability to reap disproportionate rewards relative to previous eras.^[34] This trend is likely to have influenced the evolution of prices over time, but the direction of the impact remains ambiguous. On the one hand, such firms can leverage the higher productivity to lower prices and maximise their market share. So long as this results in an increasing degree of competition, mark-ups and prices would be dampened further, flattening underlying inflation. On the other hand, if globalisation channels sales towards the most productive firms in each industry, product market concentration would rise, and competition would fall. Depending on the contestability of the market, monopolistic and oligopolistic market power would allow firms to increase mark-ups with a consequent impact on price setting.

4 The impact of globalisation on inflation in advanced economies

Empirical evidence on how global slack influences the response of inflation to domestic cyclical conditions is mixed. The early literature on the disinflationary effects of globalisation mostly focused on measures of global slack. Borio and Filardo^[35] find that the inclusion of global slack (i.e. a weighted average of international output gaps) adds considerable explanatory power to traditional benchmark inflation rate equations, thus explaining cyclical fluctuations in inflation across AEs. Lodge and Mikolajun^[36] augment a Phillips curve for a panel of AEs with measures of both global slack and global inflation and find little evidence that global slack drives domestic inflation.^[37] Global inflation is found to have had a more prominent role during the 1970s and 1980s (i.e. the Great Inflation period) but lost significance during periods of more stable inflation rates. Bianchi and Civelli^[38] find that global slack affects inflation dynamics and that globalisation, measured in terms of trade and financial openness, is positively related to the effects of global slack on inflation. However, the authors conclude that “… the effects of globalization require substantially large changes in the degree of openness in order to be economically significant”. The analysis presented in Box 1 confirms that in the case of central and eastern European EU countries their increasing integration in the world economy since the early 2000s has weakened the responsiveness of consumer price inflation to domestic conditions, though the effect is quantitatively small. This impact is more pronounced in the manufacturing sector given a higher GVC integration, hence higher exposure to international competition and strategic complementarities. Certain aspects of digitalisation (e.g. the use of internet for e-commerce) are also found to weaken the correlation between inflation and domestic cyclical conditions.

Evidence on the impact of globalisation on persistent inflation is limited and points, at best, to an economically small impact. Forbes^[39] analyses the impact of global variables on inflation dynamics and finds that while there is a positive correlation between measures of global slack and cyclical inflation, the impact on the more persistent component of inflation is not significant. Likewise, Kamber and Wong^[40] study the role of foreign shocks in driving inflation outcomes and find evidence of a sizeable influence on inflation gaps, while the impact on the permanent component is small. The negative but relatively small correlation between globalisation and the persistent component of inflation is confirmed in the analysis presented in Box 2.

Three elements of globalisation are found to be inversely related to the persistent component of inflation across AEs: trade integration, informational globalisation and GVC participation. The broad perspective on globalisation presented in this article and employed in the empirical analysis in Box 2 allows a comprehensive investigation of how globalisation can influence inflation dynamics. The findings point to the presence of compositional effects as globalisation, in its various dimensions, appears to act as a disinflationary force in the case of goods inflation, but not for services inflation. This suggests that the sharpest movements in overall inflation, which took place in the 1990s and then again after the GFC, are possibly linked to other factors, such as shifts in monetary policy regimes, falling inflation expectations and lower wage indexation. The findings are in line with the literature and hold for the cross-section of AEs analysed as well as for the euro area. Therefore this article concurs with Forbes,^[41] who finds that “global variables … have limited ability to improve our understanding of the dynamics of the underlying slow-moving trend in inflation, and they do not appear to have become more important over the last decade”. A direct implication is that while standard inflation frameworks can be augmented to account for the role of global factors, they should not be fully replaced. This is consistent with the evidence that the major plunge in inflation rates across AEs and its persistent component started in the 1980s, when globalisation was still latent and digitalisation was low, and it came to a halt around the mid-1990s, when China had not yet joined the World Trade Organization (WTO) (see Chart 2). The analysis in Box 2 further shows that the fall in inflation rates that occurred in the 1990s was synchronised across goods and services. As the latter are expected to have been relatively unaffected by cross-border integration, it can be concluded that while globalisation likely pushed down a little further the persistent component of inflation it seems unlikely to have been the main force behind its decline.

5 Conclusion

This article discussed the disinflationary role of globalisation in AEs, with a focus on the more persistent component of inflation. Drawing from the existing literature, this article reviewed three sets of factors that can explain the international co-movement of inflation and its declining path observed in the past decades. First, there are common shocks (e.g. fluctuations in commodity prices), which affect the most volatile component of headline inflation. Second, the shift in the monetary policy of several AEs towards an inflation-targeting regime and the anchoring of inflation expectations succeeded in keeping inflation steadily close to target over the past three decades and until the GFC. Third, changes in the structure of the economy that affect the wage and price-setting mechanisms can influence the more persistent component of inflation.

Evidence presented in this article shows that the disinflationary role of globalisation has been economically small. Most of the economic literature focuses on augmenting an otherwise standard Phillips curve framework with measures of global slack and shows that when controlling for such factors, the sensitivity of domestic inflation to domestic slack is diminished. While evidence of the impact on the persistent component of inflation is more limited, typically the impact is found to be smaller. This article concludes that globalisation does not appear to be a major force behind the disinflationary trends of the past decades, and any headwinds stemming from globalisation were too small to be economically meaningful. This conclusion hinges on three main elements. First, the major plunge in inflation and its persistent component started in the 1980s, when globalisation was still latent, and came to a halt around the mid-1990s, when China had not yet joined the WTO. Furthermore, the fall in inflation was synchronised across goods and services and, because of their different tradability, they should not respond homogeneously to cross-border integration. Second, and related to the latter point, evidence presented in this article suggests that globalisation has a heterogeneous impact on the sectors of the economy, with the manufacturing sector being more exposed to disinflationary forces than the services sector. This lends support to the view that globalisation leads to relative price changes but not necessarily to a decline in overall inflation. Finally, even when globalisation acts as a disinflationary force, the estimated impact is economically small. In view of this, and given that in recent years interest rates have been nearing the lower bound in many countries, a possible reason behind the persistently low inflation observed over the past decades is the limited space available to monetary policy to neutralise the influence of structural forces on inflation (either of a domestic or foreign origin).

Looking ahead, globalisation is at a crossroads. While rising protectionism seems to be threatening globalisation, growing digitalisation and services trade are also providing new impetus, shifting and re-shaping the future path of globalisation. Moreover, while global integration growth may be waning, regional trade integration appears to have been deepening both for economic and geo-political reasons. The coronavirus (COVID-19) might accelerate some of these trends, though it appears premature to draw firm conclusions about the consequences for globalisation and inflation.