Frederic Mishkin's Speech

Below is the text of a speech on "Globalization, Macroeconomic Performance, and Monetary Policy" given by Federal Reserve Governor Frederic S. Mishkin on September 27, 2007 in Washington D.C.:

Globalization, Macroeconomic Performance, and Monetary Policy

In recent years, globalization has become one of the hottest topics, not only for the general public but also for central bankers.1  Some commentators have gone so far as to claim that greater openness of economies to flows of goods, services, capital, and businesses from other nations invalidate traditional economic models of inflation, which take little account of globalization.

In the long run, monetary policy strives to achieve price stability, which contributes to maximum sustainable employment and economic growth.  In the shorter run, we at the Federal Reserve aim to achieve our dual mandate of not only stabilizing prices but also reducing the volatility of output and employment around their maximum sustainable levels.  Globalization affects the ability of monetary policy makers to stabilize prices and output in two ways: (1) through its effects on the behavior of inflation and output and (2) through its effects on the ways in which monetary policy influences inflation and output--that is, on the monetary transmission mechanism.

I will look at each in turn and will then use the analysis to address another important issue for monetary policy makers:  Has globalization been a key driver of improvements in inflation performance and the decline in inflation that we have been seeing throughout the world? 

(Please note that my comments here reflect my own views and not necessarily those of others on the Board of Governors or the Federal Open Market Committee.)

Globalization and Inflation
We should never forget Milton Friedman's adage that "inflation is always and everywhere a monetary phenomenon."  In the long run, as long as a central bank has an independent monetary policy--that is, it is not locked into a fixed-exchange-rate regime in which its hands are tied--the rate of inflation is determined by monetary policy.  Globalization, however, can have an effect on the incentives for central banks to control inflation and, more directly, on inflation developments in the short and medium runs.

Kenneth Rogoff (2003) argues that globalization has led to greater price flexibility, which has reduced the ability of central banks to use inflation surprises to boost output.  In other words, the Phillips curve will steepen, making more stark the short-run tradeoff between unemployment and inflation.  As a result, central banks will be less tempted to try to exploit the short-run tradeoff between inflation and unemployment, as in the Barro-Gordon (1983) model, and so will be less likely to pursue overly expansionary monetary policy that leads to higher inflation.  A major problem with Rogoff's argument is that instead of steepening with the growth of globalization in recent years, the Phillips curve has become flatter, not only in the United States but also in many other countries throughout the world (Borio and Filardo, 2007; International Monetary Fund, 2006; Ihrig and others, 2007; Pain, Koske, and Sollie, 2006).  Therefore, even though Rogoff's argument is reasonable from a theoretical viewpoint, it is hard to make the case that it is important in the current economic environment.

Globalization, because it makes markets more competitive, also has the potential to spur productivity growth.  Higher productivity growth can lead to a reduction in inflation because it directly lowers prices if monetary policy does not become more expansionary.  In addition, such growth makes it easier for the monetary authorities to allow inflation to fall because output growth will continue to be rapid when inflation is declining.  This may have been the situation in the United States in the late 1990s, when productivity growth surged and inflation declined.  The rise in productivity growth during this period in the United States, however, did not seem to spill over to other industrial countries, a result that cast doubt on whether globalization has indeed accelerated the transmission of productivity growth across national borders.

Because globalization increases competition, it can also reduce markups (price over costs), and this reduction may lead to lower relative prices, as is argued by Chen, Imbs, and Scott (2007).  However, lower markups and price levels should have only transitory effects on inflation.  Furthermore, the prediction of lower markups from globalization seems to conflict with the high corporate profit rates that we are currently observing around the world.

These effects from the greater price flexibility and increased competition in domestic markets that have arisen from globalization, while theoretically plausible, are often at variance with salient features of the world economy, and so they do not explain why inflation has declined in recent years.  However, another very dramatic feature of globalization is that it has brought more than a billion new workers into the global economic system from China and India.  Some observers claim that through its sales of low-cost goods, developing Asia--and especially China--has been "exporting deflation" and will continue to do so until wages in these countries rise.  Although this effect, too, is plausible, research suggests that its importance should not be exaggerated.