Globalisation: What’s at stake for central banks

Simone Arrigoni, Roland Beck, Michele Ca' Zorzi, Livio Stracca 24 February 2020

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Globalisation has been a powerful force of change that has increased productivity and played a key role in lifting millions out of poverty in emerging markets. Governments are increasingly confronted with the challenge of preserving the benefits of globalisation while managing its side effects. In this column, we highlight that central banks are also not immune to the forces of globalisation in at least three dimensions. First and foremost, globalisation may have an impact on inflation. Second, it may complicate central banks’ role in supporting financial stability. Finally, globalisation may influence central banks in subtler and more indirect ways. We review each aspect on the basis of recent evidence and academic literature.

Has globalisation made inflation more dependent on global factors?

It has been stressed in the recent international finance literature that globalisation has made inflation more dependent on international factors and put into question the usefulness of standard economic models (Forbes 2020). It is indeed well known that inflation has a strong global component, driven in particular by commodity prices for headline inflation.1 Recent work has also shown that globalisation is affecting inflation through several additional channels that may help explain the lack of inflationary pressures in the recovery phase after the global financial crisis. Notably, foreign slack can influence domestic inflation by reducing the bargaining power of labour. Globalisation has further decreased the bargaining power of workers as firms can offshore their technological knowhow (Baldwin 2016). The expansion of global value chains may have also enhanced the economic relevance of global economic slack for domestic inflation by increasing international linkages (Auer et al. 2017). Last but not least, there is evidence that rising trade exposures explain the decline in responsiveness of aggregate inflation to output fluctuations across industries (Gilchrist and Zakrajsek 2019).

The above findings prompt the more general question of whether globalisation leads to higher co-movements of macroeconomic and financial variables, whose assessment are essential for the conduct of monetary policy. In theory, this is not necessarily the case because, on the one hand, integration increases the degree of global interdependence but, on the other hand, it fosters economic specialisation and risk sharing. Overall, the empirical evidence however supports a positive link between trade and financial integration and international co-movements.2

In this context, a simple correlation analysis reveals some interesting stylised facts. In Figures 1 and 2 we show the average bilateral correlations of major real and financial variables during a period of relatively low (pre-2003) and high globalisation (post-2003, omitting the years of the global financial crisis). In both periods we find that cross-country correlations are higher than in standard economic models (Justiniano and Preston 2010). This international synchronisation has generally risen further with the deepening of economic and financial integration but not for all variables. While the rise was particularly sizeable in the case of real variables and stock market returns, there was even a slight decline in the case of headline inflation and financial conditions between the two samples. 

Figure 1 Real variables

Sources: IMF International Financial Statistics, OECD Main Economic Indicators, Haver Analytics, Refinity Datastream and ECB Staff calculations. 
Notes: Averages (unweighted) of bilateral correlations based on quarterly data for 53 countries; annual growth rates; GDP and components are expressed in real terms. 

Figure 2 Financial variables

Sources: IMF International Financial Statistics, OECD Main Economic Indicators, Haver Analytics, Refinity Datastream and ECB Staff calculations.
Notes: Averages (unweighted) of bilateral correlations based on quarterly data for 53 countries, except for financial conditions whose sample covers 43 countries; annual growth rates except for financial conditions (levels); bond yields refer to long-term yields; house prices are expressed in real terms while credit measures are nominal.

Moreover, the cross-country correlation of core inflation and GDP deflator is much lower than for headline inflation in both sample periods, confirming that a large share of the co-movement in headline inflation can be ascribed to fluctuations in commodity prices. 

Another relevant consideration for central banks is at which frequency inflation is measured. As stressed by Carney (2005), the degree of co-movement of inflation across countries tends to rise at lower frequencies, which is confirmed by the evidence shown in Figure 3. This does not necessarily imply that inflation is itself more driven by global factors over the medium term, as it could also be a result of central banks behaving in a more similar way and relying on a similar analytical framework during the Great Moderation, i.e. a ‘globalisation of central banking’. Indeed, in a recent study Kamber and Wong (2020) claim that global factors play a marginal role in driving trend inflation. 

Figure 3 Average country pairwise correlation at different frequencies

Sources: IMF International Financial Statistics, Haver Analytics and ECB Staff calculations.
Notes: Averages (unweighted) of bilateral correlations based on quarterly data for 53 countries over the period 1980q1-2018q4.

In terms of monetary policy transmission, it is also often argued that globalisation weakens central banks’ control over domestic financing conditions. For example, Arregui et al. (2018) find that global factors account for about 20% to 40% of the variation in countries’ domestic financial conditions’ indices, consistent with the notion of a global financial cycle (Rey 2013). 

However, as shown in Figure 2, this conclusion mainly stems from co-movements in stock prices, which are known to be largely driven by co-movement in risk premia (Jorda et al. 2017). Bond yields, on the other hand, display lower co-movement, as do other financial variables, in particular those that are known to be the best predictors of crises, such as credit and house prices.

Higher trade and financial integration may also increase the international transmission of monetary policy, leading to the question of whether major central banks should take monetary policy spillovers into account (Lane 2019b). Recent ECB research estimates the international effects of monetary policy shocks in the US and the euro area (Ca’ Zorzi et al. 2020). This paper finds that the spillover effects of monetary policy between the euro area and the United States on output and inflation are small, despite notable spillovers from Federal Reserve monetary policy to euro area financial markets. ECB and Fed monetary policy shocks have instead larger effects on emerging market economies. Since the impact on these countries ‘spills back’ domestically, international considerations may matter for central banks out of ‘enlightened self-interest’ (Caruana 2015). However spill-backs are time-varying and challenging to measure, albeit their importance may have risen with the increasing weight of emerging markets in the global economy.

Globalisation and financial stability

In the aftermath of the global financial crisis central banks have been typically assigned a larger role in contributing to financial stability, in cooperation with other authorities. The ECB, for example, has been given supervisory and macro-prudential powers for euro area banks with the creation of the Single Supervisory Mechanism (SSM) in 2014. 

In light of this enhanced role, central banks are also evaluating the links between globalisation and financial stability. While in theory access to international capital markets should lead to more risk sharing, there is a widespread perception, particularly after the global financial crisis, that globalisation could increase financial stability risks (Broner and Ventura 2011). Some economists have even claimed that a financial trilemma exists (Schoenmaker 2011), with only two of the three objectives of (i) financial stability, (ii) independent national financial policies and (iii) cross-border financial integration, able to be achieved simultaneously. The corollary of the financial trilemma is that, unless policymakers are prepared to tame globalisation, the transfer of greater regulatory and supervision policies away from national institutions becomes a necessity to preserve financial stability. 

While there has been progress in the coordination and regulatory policies in international fora such as the BIS and FSB, the quality of financial globalisation is also important for preserving financial stability. For example, equity rather than debt integration may reduce the domestic cost of crises as losses are partly borne by foreign investors (Lane 2019a).

Another strand of the literature has explored more directly the link between globalisation and financial crises. Even if crises are best predicted by credit booms (Schularick and Taylor 2012), which are to a large extent domestic, more recent evidence suggests that some banking crises also have an important global dimension. For example, Cesa-Bianchi et al. (2019) argue that foreign credit growth has a large positive effect on the probability of domestic banking crises, even when controlling for domestic credit growth. 

This does not imply, however, that domestic financial stability is at the mercy of international factors. Recent ECB research has shown that the contribution of foreign credit growth to the probability of domestic crises can be mitigated by using macro-prudential policy tools (Beck et al. 2020). Overall, there is an increased consensus that greater reliance on macro-prudential tools helps insulating countries from foreign shocks. The optimal design of monetary and macro-prudential policies in response to sizeable capital inflows remains, however, a major challenge, especially for emerging economies.3 More research is also needed to understand how macro-prudential policies may redirect capital flows to other destination countries (Forbes et al. 2016).  

Other challenges

Moving beyond the concerns related to the maintenance of price and financial stability, globalisation influences central banks in subtler and more indirect ways. We briefly touch upon five dimensions in particular.

First, protectionist pressures may have significant repercussions on the global economic outlook and pose a direct challenge for central banks in the near term. To the extent that, for example, tariff increases represent negative supply shocks they create an unfavourable trade-off for monetary policy (ECB 2019). However, this trade-off is weakened when the central bank credibly commits to its price stability objective (Cœuré 2013).

Second, the activities of multinational companies and financial centres are profoundly changing the nature of global financial integration and in particular the quality of economic statistics that are essential for central bank analysis such as the assessment of external exposures.4 

Third, central banks are also subject to enhanced international competition and possible disruption from digitalisation. The possible emergence of competing forms of money through digital innovations at the global level have been a wake-up call for central banks to promote faster, more reliable and less costly payment systems and to reassess the benefits and costs of issuing central bank digital currencies (Boar at al. 2020).

Fourth, the anti-globalisation backlash, more than globalisation itself, has challenged the consensus in favour of central bank independence (Goodhart and Lastra 2018). Recent empirical evidence for developing countries also supports the notion that there may be a negative link between the rise in national identity politics and the acceptance of central bank independence (Agur 2018).5 

Finally, climate change, which can be seen as partly fostered by globalisation, is perhaps the key global challenge of our time. Although central banks are certainly not at the forefront of the global effort to fight climate change, they have to deal with its consequences for price and financial stability, as well as facilitate the transition, led by other policymakers, to a low carbon economy.

Overall, central banks are far from immune from the forces of globalisation and have an interest that the responsible policymakers properly manage its evolution and make it sustainable and equitable. On their side, central banks should continue to evolve and reassess their role and instruments in a changing world, as indeed several major central banks are doing with their strategic reviews.

Authors’ note: We thank P. Lane, H.J. Klöckers and D. Lodge for very helpful comments. The views expressed in this column belong to the authors and are not necessarily shared by the European Central Bank. 

References

Agur, I (2018), “Populism and central bank independence: Comment”, Open Economies Review 29(3): 687-693.

Arregui, N, S Elekdag, R G Gelos, R Lafarguette and D Seneviratne (2018) “Can countries manage their financial conditions amid globalization?”, IMF Working Papers 18/15.

Auer, R, C Borio and A Filardo (2017), “The globalisation of inflation: the growing importance of global value chains”, BIS Working Paper 602.

Avdjiev, S., Everett, M., Lane, P.R. and Shin, H.S. (2018), “Tracking the international footprints of global firms”, BIS Quarterly Review, March.

Baldwin, R (2016), The Great Convergence: information technology and the new globalisation, Harvard University Press.

Baxter M and M Kouparitsas (2005), “Determinants of business cycle comovement: a robust analysis”, Journal of Monetary Economics 52(1): 113-157. 

Beck, R, M Ferrari and H Groeger (2020), “The best of both worlds - mitigating the side effects of financial globalisation”, Working Paper, European Central Bank, mimeo.

Boar, C, H Holden and A Wadsworth (2020), “Impending arrival – a sequel to the survey on central bank digital currency”, BIS Papers, 107.

Borio, C (2019), “Central banking in challenging times”, Speech at the SUERF Annual Lecture Conference on “Populism, Economic Policies and Central Banking”, SUERF/BAFFI CAREFIN Centre Conference, Milan, 8 November 2019.

Broner F and J Ventura (2011), “Globalization and risk sharing”, The Review of Economic Studies 78(1): 49–82. 

Ca’ Zorzi, M, L Dedola, G Georgiadis, M Jarociński, L Stracca, and G Strasser (2020), “Monetary policy and its transmission in a globalised world”, ECB Working Paper, forthcoming.

Carney, M (2015) “Inflation in a globalised world”, remarks at Economic Policy Symposium hosted by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 29 August 2015.

Caruana, J (2015), “Beyond zero rates and unconventional monetary policy”, panel remarks at the Sixth Annual Conference organised by the Central Reserve Bank of Peru and the Reinventing Bretton Woods Committee, on “Monetary and financial shifts: challenges and possible outcomes”, Lima, 6 October 2015.

Cœuré, B (2013) “Monetary policy in the crisis – Confronting short-run challenges while anchoring long-run expectations”, Speech at the Journées de l’AFSE 2013, Université d’Orléans, 17 May 2013.

Cesa-Bianchi, A, F E Martin and G Thwaites (2019), “Foreign booms, domestic busts: The global dimension of banking crises”, Journal of Financial Intermediation 37: 58-74.

Ciccarelli, M and B Mojon (2010), “Global inflation”, Review of Economic Statistics 92(3): 524-535.

European Central Bank (2016), “The layers of the global financial safety net: taking stock”, ECB Economic Bulletin, Issue 5.

European Central Bank (2017), “Domestic and global drivers of inflation in the euro area”, ECB Economic Bulletin, Issue 4.

European Central Bank (2019), “The economic implications of rising protectionism: a euro area and global perspective”, ECB Economic Bulletin, Issue 3.

European Central Bank (2020), “Multinational enterprises, financial centres and their implications for external account imbalances: a euro area perspective”, ECB Economic Bulletin, forthcoming.

Forbes, K (2019), "Inflation dynamics: dead, dormant, or determined abroad?”, NBER Working Paper 26496.

Forbes, K, M. Fratzscher, T Kostka and R Straub (2016), “Bubble thy neighbour: Portfolio effects and externalities from capital controls”, Journal of International Economics 99: 85-104.

Gilchrist, S and E Zakrajsek (2019), “Trade Exposure and the Evolution of Inflation Dynamics”, Finance and Economics Discussion Series 2019-007, Board of Governors of the Federal Reserve System. 

Goodhart, C and R Lastra (2018), “Populism and central bank independence”, Open Economies Review 29(1): 49-68.

Imbs, J (2006), “The real effect of financial integration”, Journal of International Economics 68: 296-324.

Jorda, O, K Knoll, D Kuvshinov, M Schularick, and A M Taylor (2019 [2017]), “The rate of return on everything, 1870-2015”, The Quarterly Journal of Economics 134(3): 1225-1298.

Justiniano, A and B Preston (2010), “Can structural small open-economy models account for the influence of foreign disturbances?”, Journal of International Economics 81(1): 61-74.

Kamber G and B Wong (2020), “Global factors and trend inflation”, Journal of International Economics 122(C). 

Lane, P R (2019a), “Globalisation: A macro-financial perspective - Geary Lecture 2019”, The Economic and Social Review 50 (2): 249-263.

Lane, P R (2019b), “Globalisation and monetary policy”, speech at the University of California.

Lane, P R and G M Milesi-Ferreti (2017), “International financial integration in the aftermath of the global financial crisis”, IMF Working Papers 17/115.

Milesi-Ferretti, G M (2019), “Measuring international financial integration: new challenges”, Keynote Presentation at the 16th Annual NBP-SNB Joint Seminar “Current account and exchange rate adjustment”.

Rey, H (2013), “Dilemma not trilemma, the global financial cycle and monetary policy independence”, paper presented at Jackson Hole, August 24.

Rogoff, K (2019), “How central-bank independence dies”, Project Syndicate, 31 May 2019. 

Scheubel B, L Stracca and C Tille (2019), “Taming the global financial cycle: what role for the global financial safety net?”, Journal of International Money and Finance 94(C): 160-182.

Schoenmaker (2011), “The financial trilemma”, Economics Letters 111(1): 57-59. 

Schularick, M and A M Taylor (2012), “Credit booms gone bust: Monetary policy, leverage cycles, and financial crises, 1870-2008”, American Economic Review 102 (2): 1029–61.

Tille, C (2019) “The many faces of spillovers: what have we learnt, what do we yet have to learn?”, keynote lecture at the BIS, BoE, ECB, IMF workshop “Policies to harness global financial interconnectedness”, Basel, 25 April 2019.

Endnotes

1 For a central banking perspective on the domestic and foreign drivers of inflation (e.g. Ciccarelli and Mojon 2005, ECB 2017). 

2 For more systematic evidence on the link between trade and financial integration and co-movement, see Baxter and Kouparitsas (2005) and Imbs (2006).

3 In the context of a simplified macro model, Tille (2019) has recently shown that, under the restrictive assumption that the implementation of macro-prudential measures is costless, there is a clean split in the roles of macro-prudential and monetary policies. Macro-prudential policies should then simply handle domestic credit shocks while interest rate policy should stabilise inflation and the output gap. What is insightful in the context of our discussion is how both policies react to foreign inflows, namely macro-prudential policies to tame their impact on credit while interest rate policies to tame their impact on output growth. 

4 On the impact of multinational companies on the measurement of macroeconomic variables and external imbalances, see Avdjiev et al (2018), Milesi-Ferretti (2019) and ECB (2020).

5 For further discussion on the recent debate on central bank independence, see Borio (2019) and Rogoff (2019).

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Topics:  EU institutions Macroeconomic policy

Tags:  Central Banks, globalisation, eurozone, monetary policy

Research Analyst, Directorate International and European Relations, ECB

Senior Team Lead Economist at the European Central Bank (ECB)

Lead Economist in the Directorate International and European Relations, European Central Bank

Deputy Director General International and European Relations, European Central Bank.

CEPR Policy Research