A Narrow Window On The World

Global trends affect U.S. inflation, but the Fed isn't paying enough attention

When Federal Reserve Bank of Dallas President Richard W. Fisher called for a limousine to London's Heathrow Airport, a woman with a British accent answered. As soon as Fisher opened his mouth, she switched to a Texas drawl. "Who are you?" asked Fisher. The answer? A call center operator in Bangalore who could match a Texas accent from having watched episodes of Walker, Texas Ranger.

By now, every central banker, like every business executive, has a tale about the new workings of the global economy. Former Fed Chairman Alan Greenspan regularly highlighted globalization in his speeches.

Yet the Fed has lagged in one critical respect. Surprisingly, its all-important forecasts of future U.S. inflation -- which help determine monetary policy -- are still based mainly on domestic factors, such as U.S. unemployment. Imports enter into the inflation equation, but with less weight. And there is no direct role for, say, rapid capacity growth in China and India.

Economists, both within and outside the Fed, have raised questions about this. In a May 22 speech, Fisher noted that "models that do not adequately incorporate globalization are likely to result in policy responses that might be too strong or too weak, too soon or too late." And in a speech last fall, Fed Governor Donald L. Kohn, who was recently nominated as the Fed's Vice-Chairman, said: "To act as if the outside world does not matter flies in the face of the major changes we have witnessed in recent decades."

Provocative new studies from the Bank for International Settlements and the International Monetary Fund suggest that the Fed's model could significantly underestimate the global economy's impact on U.S. inflation. In a March paper, two BIS economists found that global measures of tightness play a bigger role than domestic factors in determining inflation in the U.S. and 14 other industrial nations. And the IMF recently concluded that inflation in the U.S. and seven other advanced countries is less sensitive to domestic economic growth than in the past, due in part to global forces.

Nailing down the link between the global economy and U.S. inflation won't be easy. Finding the right indicators of inflationary pressure in the U.S. is hard enough. The job is much more difficult when economists have to make calculations for China and other countries not known for solid statistics.

Globalization may end up as the defining issue for Fed Chairman Ben S. Bernanke, as productivity was for Greenspan, who made his reputation by recognizing the link between faster productivity growth and lower inflation. Today, many economists say that globalization is the X factor explaining why inflation has stayed low so long.

Of course, what goes down might go up, too. One danger is that U.S. inflation, which is finally picking up, might rise even higher if nascent expansions in Japan and Europe take hold. But no matter how things play out, the era of a purely domestic monetary policy is over.

By Catherine Yang

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