Borio-Filardo Globalization and inflation:

New cross-country evidence on the global determinants of inflation

Comments by Neven Mates

How the globalization affects inflation • Many channels through which globalization contributed to the sharp

decline in global inflation over the last 10 years, including: (i) reduced rigidities of wages and prices in the context of stronger international competition.This has reduced the optimal inflation rate and the costs of disinflation; (ii) in more open economies, the benefits of unexpected inflation have become smaller; (iii) the costs of devaluations that could result from pro-inflationary policies has gone up; (iv) positive supply shocks as China and transition countries have become large exporters of manufacturing products.

• Some of these factors have created incentives for policy-makers to grant a higher degree of independence to central banks and give them a clear mandate to focus on inflation;

• Some of them have made disinflation politically more palatable.

B&F paper: issue and instruments

• The main issue of the paper: To which extent has the globalization reduced the importance of domestic gaps and increased the importance of partner-country and global gaps in explaining inflationary developments in individual countries?

• Main instrument: Different versions of reduced-form Phillips curves in which inflation depends not only on domestic gap but also on partner country and global output gaps.

• The gaps are extracted from the data with the help of uni-variate filters.

B&F paper: conclusions

• The picture that arises is one of multiple models and overwhelming evidence, all of them pointing to the fact that, as globalization progressed, the importance of global gaps weakened, and that of global gap/gaps has strengthened.

• However, the result that the importance of domestic gaps was effectively eliminated in most countries strikes a reader as implausible. Moreover, the result seems to be less robust to inclusion of control variables than the authors claim.

• The models seem to have many econometric problems.

Model 3: Global gaps are superiorin explaining inflation

• In 16 (out of 17) countries, various measures of partner country gaps are highly significant (at 5 percent or better);

• The domestic gap is significant in only 3 countries at 5 percent or better, and at 10 percent in another 3.

• The size of the domestic gap coefficients is in all cases (except one) smaller than for partner-country gaps. In five cases, the sign for domestic gaps has become even negative, albeit not significant.

• Even in the USA of all places, the domestic gap becomes insignificant, suppressed by the dominant role of the external gap.

Models 1 and 2

• Model 1 seems to show that the significance of domestic gaps dropped when 1982-92 is compared with 1993-2005.

• Model 2 is based on pooled data for 1985-2005: Both domestic and foreign gaps are significant, but the coefficients for foreign gaps are larger than for domestic gaps.

Congratulate the authors on mission accomplished, or …

•

Alternative explanationfor B&F findings:

• Shift to low inflation regime has made the estimation of inflation dependence on domestic output gap more difficult: the coefficient estimateses have become less reliable and more biased.– Laxton, Shoom and Tetlow paper from 1992: The reduced form

estimates of the Phillips curve, which are based on potential output obtained via single-variable filters, are biased and always underestimate the true gap coefficient. The bias gets bigger when the variability of inflation and gaps declines.

– Lower inflation=>Measured gap coefficient underestimates the true coefficient by a larger margin. The decline the gap coefficient reflects increasing missmeasurement as inflation declines.

• This very much invalidates results of Model 1 and Model 3.

Models 1 and 2:weak statistical properties

• Other factors also point toward weak statistical properties of Model 1 and Model 2;

• In Model 1, the decline in the gap coefficient is significant in only four cases.

• More importantly, the specification of that model requires simultaneous estimation of the autoregressive component and the gap coefficient. The authors themselves demonstrate in an appendix such estimates are highly unreliable;

• But they do not seem to accept that this weakens all the results of that model. Regarding Model 2, the authors enumerate all the tests that the model failed. No need to add anything on that.

Some opinions on connectionbetween successful monetary policy

and PC flatteningning

• Papademos: When central banks successfully bring inflation down, the link between inflation and gaps in reduced form equations appears as weaker, and even non-existent.

• Bean: “Observational flattening of the Phillips curve” can be result of a declining natural rate of unemployment, combined with successful inflation targeting regimes, which would actually leave the slope of the real short term Phillips curve unchanged.

Why the estimation of global gap impact could be less prone

to this difficulties?• In times when successful monetary policy efficiently controls

“domestic” component of inflation, most variability in inflation comes from “the imported component”. With the domestic gap coefficient underestimated, this might create a wrong picture about the true size of coefficients.

• Moreover, the impact of output gap on inflation could be veiled in case when monetary authorities systematically use monetary policy to partly compensate effects of supply shocks on inflation. If an oil price hike increases price pressures and monetary policy reacts with tightening, the the result could be a negative correlation between the gap and inflation in several periods ahead.

• Unless one specifies all supply shocks and integrates monetary policy in the model, the contribution of domestic gap/slack cannot be precisely estimated.

Conclusion

• Globalization has indeed affected inflation over the last 10 years;

• But pronouncing the death of domestic gaps seems to be premature;

• Simple reduced-form equations are hardly adequate to provide realible estimates of factors driving dynamics of gap coefficients.