Why Foreign Inflation Matters to Janet Yellen

HSBC, Bank of America say global output gap will cap price pressures

All Eyes on Yellen as Markets Await Rate Decision

Janet Yellen may be about to discover that if all politics is local, all monetary policy is global.

As her Federal Open Market Committee prepares to increase interest rates this week, its scope to keep doing so in 2016 may be limited by events abroad, according to economists at HSBC Holdings Plc and Bank of America Corp.

“Fed policy will continue to be steered by developments elsewhere,” Janet Henry, HSBC’s chief global economist, told clients in a report on Monday. “To keep tightening in the way the FOMC currently projects it will need to be very confident about the ability of the U.S. economy to withstand the disinflationary pressures that the rest of the world will still be trying to export elsewhere.”

There are many reasons to think international inflation trends will restrain American price pressures. Commodities are renewing their slide with oil below $35 a barrel for the first time since 2009. Emerging markets are still weakening and geopolitical threats are again flaring up.

Output Gap

The potential is therefore for U.S. inflation to be kept in check by soft foreign demand, weak import prices and a strengthening dollar regardless of how well the domestic labor market performs. Behind the theory is the argument that globalisation has increased competition for goods and labor, reducing international prices.  

Yellen and her fellow central bankers are alert to the risks. They already calculate the dollar’s 15 percent rise since June 2014 was equivalent to a full percentage point of rate hikes and they cited “global economic and financial developments” when not raising rates in September after China wobbled.

The need to monitor overseas is best demonstrated by the global output gap, which measures the difference between the world economy’s trend rate and its actual expansion. The bigger the gap, the weaker international inflation likely is.

Henry estimated that even as the U.S. strengthens, the global divergence will widen to almost 1.7 percent of gross domestic product next year as developing economies fade. Stripping out the U.S. leaves an international shortfall of 1.9 percent.

That’s different from when the Fed last began lifting rates in the 2004 as back then the U.S. and world economies were outpacing their trends. Indeed, the previous time the U.S. output gap broke with the rest of the world was during the 1997 Asia crisis. On that occasion, the resulting financial market instability eventually toppled hedge fund Long-Term Capital Management and led Alan Greenspan’s Fed to cut rates.


Now HSBC says the Fed will have to revise its thinking after the median of its officials in September was for its benchmark to be 2.60 percent in 2017. HSBC predicts it will be no higher than 1.5 percent.

“Our forecast is much closer to the markets’ current expectations than to the Fed’s,” said Henry.

Less sure is Paul Donovan, an economist at UBS Group AG, who argues local factors still dominate inflation baskets outside of commodities, limiting the effect of the global output gap. 

Also warning that inflation is a global phenomenon that should worry all central bankers is Gilles Moec, chief European economist at Bank of America. A study by his team of 23 developed countries from 1960 to 2015 found a “very tight” correlation between the world’s inflation and its output gap.

That puts the European Central Bank under pressure to provide more monetary stimulus and also impacts central banks such as the Bank of England whose domestic conditions may otherwise merit higher rates, said Moec, a former Bank of France official.

“If you look at the impact of global inflation trends on local inflation and how strong the correlation is, central banks definitely need to take that into account,” he said. “You have to generate enough output gap-absorption locally to offset the global capacity.”

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