From The Hill
Weak inflation is one of the “major challenges” of our time, according to Federal Reserve Chairman Jerome Powell. Not only does persistently low inflation limit the scope of monetary policy, it may also have a damaging impact on the financial system. But the inflation forecasts used by the Federal Reserve to set monetary policy have not been performing very well lately. When the global financial crisis erupted in 2008 and growth collapsed around the world, why did inflation not fall further? As growth has picked up in the United States and unemployment has gone down, why has the inflation rate in this country remained so stubbornly low?
One key to the puzzle may be the forecasts themselves. The frameworks that macroeconomists have relied on to predict inflation primarily use domestic variables dating back to the “Phillips Curve” of the late 1960s which showed that inflation increases when unemployment falls. But the forces that drive our economy are not only confined within our national borders. The models miss what is happening across the rest of the world.
Over the last two decades, globalization has proceeded quite rapidly. Trade flows have increased, emerging markets have achieved greater economic heft and power, more and more companies are using global supply chains to shift parts of their production to cheaper locations, and workers have lost bargaining power in many countries across the world. It is intuitive that these factors would have an impact on prices. However, none of them are currently captured in the standard frameworks that are used to forecast inflation for major countries such as the United States.
Read the full post at The Hill.
Kristin Forbes is the Jerome and Dorothy Lemelson Professor of Management and Global Economics at MIT’s Sloan School of Management.