Kristin Forbes, Jerome and Dorothy Lemelson Professor of Management and Global Economics, MIT Sloan School of Management.
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.
Trying to predict currency movements is — as they say here in the U.K. — a mug’s game. Any economist, myself included, will tell you it’s virtually impossible to do.
And yet, movements in exchange rates are incredibly important. They affect a country’s competitiveness — influencing everything from export competitiveness to GDP growth. They affect the prices of items coming from abroad, from oil to oranges to iPhones. They make it harder, or easier, to repay foreign debt and they affect earnings on foreign investments.
Currency movements also have big implications for the outlook for inflation. This relationship is known as “pass-through,” because it captures how changes in the exchange rate “pass-through” to import prices and then inflation.
So even if we can’t predict exchange rate movements, we need to understand how exchange rates will affect the economy. And for those of us tasked with setting monetary policy, understanding how currency movements pass-through into inflation is critical to our decision on when to adjust interest rates.
The problem is, much of what we thought we knew about pass-through has not been holding up well.
When we set out to find a visionary and thinker in the financial sector to add to our collection of interviews, Kristin Forbes’ name was suggested to us by other economists, as well as from other women her age in finance, the arts and by those equally formally educated, who have opted to stay at home and raise kids. It was one of the first times that such a varied range of people suggested someone to us.
We began to research her. We were intrigued that the Bank of England had selected this American economist to join their Monetary Policy Committee as one of two external members. And we were curious about hearing from someone who was in the White House during President Bush’s years, a controversial President, and who watched the collapse of the financial markets that has brought forth finger pointing and reform. But what interested us most was that this MIT Professor was one of the earliest thinkers to focus on financial contagions. I sat down with Kristin to discuss contagions, the current thinking on energy, inflation and economic growth.
Last week, Turkey’s central bank surprised investors by raising a key interest rate to 10 percent from 4.5 percent. It was a bold move to rein in inflation and calm the markets. But Turkey’s prime minister, Recep Tayyip Erdogan, has been vocal in blaming the “interest-rate lobby” — a supposed conspiracy of foreign bankers, and some economists and journalists — for volatility in stock prices and a steep decline in the lira.
Turkey is far from the only country to blame foreigners for recent market turmoil. Venezuela’s president, Nicolás Maduro, recently complained of a “psychological war from abroad.” The governor of the Central Bank of Brazil, Alexandre Antônio Tombini, describes rising interest rates in rich countries as a “vacuum cleaner” that indiscriminately sucks capital out of emerging markets.
What began as a singular sovereign debt problem in Greece in 2009 quickly spread to the rest of Europe. First Ireland; then Portugal and Spain and Italy. Today—only three years after the first signs of trouble—virtually all Europeans have felt the destructive effects of the euro zone turmoil, and its impact is being felt around the world.
Contagion, a phenomenon where financial tumult in one country or region spreads to another country, is now a fact of life. The globalization of finance has, in many ways, made contagion inevitable. The world has become much more integrated through trade, investors, and banks, and these ties have caused countries’ financial markets to move together more closely during good times and bad. Read More »