September 15, 2006

Globalization and Monetary Policy.  If you get a chance, pick up the September 14, 2006 edition of The Economist magazine.  The Economist is always an excellent source of information but this week they have a special survey of the World Economy.  It is an outstanding series of articles including a discussion of the impact emerging markets are having on the rich countries.

One of the more interesting areas of discussion, to me at lease, is the impact emerging markets and globalization is having on monetary policy.  Think about the fact that interest rates are, by historical standards, very low.  Back in 2003 they were at their lowest levels in over 40 years.  At the same time, globalization and the IT revolution were steaming ahead. 

Today we are worrying about growing inflationary pressures, imbalances in financial markets and the potential for a slowing U.S. economy.  Why did this happen and what will happen next in the short run?

To answer the latter see the second Macroeconomic Update podcast at: http://media.mccombs.utexas.edu/MacroUpdates/Macro2.wmv

In addressing the question of “what happened” we need to decide WHY central banks continued to cut interest rates throughout 2002 and 2003.  One explanation is that the central banks feared deflation.

Deflation, continual decreases in the general level of prices, can be just as destructive as inflation.  Deflation brings back memories of the Great Depression, when firms slashed output, uncertain if they would be able to cover their costs.  History is riddled with examples of deflationary economic death spirals that dragged on for decades.  The experience of Japan in the 1990’s convinced many central bankers that deflation is still a modern day problem.

So, when inflation rates fell below the central banks’ target of around 2%, central banks cut interest rates.  As inflation rates continued to fall central banks cut interest rates even further in an attempt to stop the deflationary onslaught.  As the economy expanded and prices remained flat, central banks held interest rates low.

But…was it all a mistake?

Perhaps prices were falling due globalization and the IT revolution.  Globalization allows rich countries to buy many goods and services (those G&S were rich countries do not have comparative advantage) from poorer nations at lower prices.  Thus, the falling inflation rates may have been a positive outflow of the interconnection of the world’s economy.

And then there is IT revolution.  With advancements in technology have come advancements in productivity.  These advancements in productivity allow producers to pass cost savings along to their customers in the form of lower prices.  Increases in technology, or what economists call positive supply shocks, result in lower prices and more rapid economic growth.

So maybe the rich countries can grow with inflation rates at well less than the central banks target of 2%.  If this is the case than it is a mistake to continue to cut interest rates as the inflation rate falls below 2%.  “Excessively low” interest rates require increases in the growth rate of the money supply.  But remember, if the money supply increases too rapidly the economy can suffer from inflation.

One of the problems with monetary policy is that it all happens with a lag.  That is, changes in monetary policy today are not felt until well into the future.

So are we now starting to feel the effects of the excessively expansionary monetary policies of 2002 and 2003?  Look at the growing signs of inflation.  It makes one wonder.

It was a Glut.

The other explanation for what happened is that there was a “global savings glut.”  This idea, put forward by Ben Bernanke before he became Fed Chair, states that many economies around the world have excess amounts of savings.  Due to a lack of profitable investment opportunities at home these high savings rates make their way into the global financial markets.

As the U.S. economy grows and expands it attracts this foreign savings.  That is why the U.S. has a large current account deficit and why U.S. interest rates have remained so low as the economy has expanded.  The Fed had no choice to lower interest rates and keep them low or else even more money would have flowed into the U.S.

Under this argument, as the rest of the world’s economies start to expand there becomes investment opportunities in these economies.  Thus, U.S. interest rates can return to more normal (or less accommodating in Fedspeak) levels.  This is what we have seen recently as the Fed has increased interest rates 17 of its last 18 meetings.

So which story do you believe?  As with so much else in economics there are no clear easy answers.  It will be interesting to see how the Federal Reserve’s Open Market Committee decides to deal with this issue.

Hope you enjoy the podcast!

All the best,

MBrandl