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Fed Gets Big Picture Respite

The Federal Reserve Bank of Kansas City's annual monetary policy conference in Jackson Hole, Wyoming, couldn't come at a better time for Fed officials.
For months, U.S. monetary policy - now on pause after two years of steady tightening - has been largely dependent on economic data, leaving officials and investors alike captive to the twists and turns of numbers, whether it's underlying consumer price figures rising 0.2% or 0.3% or the jobless rate ticking up a notch or two.

But data-dependent officials well get a chance late this week to work their intellectual muscles with perhaps the biggest of big picture topics: globalization and its effect on the economy and monetary policy.

The two-day event kicks off Friday with a speech by Fed Chairman Ben Bernanke, and includes papers and remarks from academics and central bank officials from around the world.

While globalization may not have much of an impact on the next consumer price or employment report, its effects on the U.S. economy have been felt for years, and will be felt for years to come, through international trade and wages as well as energy and commodity prices, economists said.

"What's going on with business cycles around the world is very important for U.S. inflationary forecasts," said Lakshman Achuthan, director of the Economic Cycle Research Institute.

Expansionary global monetary policies following the 2001 U.S. recession "produced the strongest wave of global economic growth in forty years," said analysts at Bridgewater Associates in a research note.

"This growth has pushed commodities prices substantially higher because the supply of commodities is constrained. But it has not pushed wage rates substantially higher because the supply of labor has expanded," they said.

Given those disinflationary labor and inflationary commodity crosscurrents, "it's a tougher environment for a central banker," Achuthan said.

Contrasting Views At Fed

Recent remarks by Fed officials suggest the topic of globalization is clearly on their radar screen, though it seems to have contrasting implications for U.S. inflation.

One school of thought is that increased integration of the world economy and the industrialization of developing countries like China and India have contained inflation in the U.S. by providing low-cost labor. That means the U.S. can operate at higher rates of capacity utilization and lower unemployment rates than previously thought without triggering price pressures.

In an April speech, Dallas Fed President Richard Fisher said "the Fed has been able to contain inflation with faster growth than would have been possible in the absence of globalization."

"The secular impact of enormous new capacity and factor inputs from China, India and the other new economic entrants - transmitted through globalization - has offset the price pressures on commodities and other goods that have been spurred by growing demand in those countries, as well as normal cyclical price developments," he said.

In a June speech, Fed Vice Chairman Donald Kohn downplayed the effects of globalization on inflation, saying "the effects of globalization on domestic inflation need not even be negative, especially in today's environment of strong global growth."

Import prices, Kohn noted, have in recent years risen at about the same average pace as core prices, "and thus no longer appear to be acting as a significant restraint on inflation in the United States."

"I would say so far Fisher's got the upper hand" with the notion of globalization as a broadly disinflationary force, said John Silvia, an economist at Wachovia.

"In the very short run you've added global capacity to produce goods," he said, which "at the margin has created more capacity to produce goods at a low price and hold down U.S. inflation."

"I would probably say the (disinflationary) impact is still for another five or 10 years," said Silvia.

Overseas Rate Hikes Could Help Fed

A more immediate instance in which globalization may help the Fed in its effort to achieve a soft landing amid signs of weaker U.S. growth and uncomfortably high inflation is monetary policy.

Though the Fed recently paused its two-year tightening campaign with the Fed funds rate at 5.25% - and financial markets are increasingly betting that it will peak there - other major central banks are hiking rates, which analysts say could act as a restraint on U.S. inflation even in the absence of Fed tightening.

The European Central Bank and Bank of England each raised interest rates this month, as did the Bank of China.

"Foreign central banks raising short-term interest rates would tend to have a short-term damping effect" on U.S. growth and inflation, Silvia said. He said that higher overseas interest rates would lower U.S. exports abroad, slowing growth, and drive up U.S. market interest rates as global capital shifts overseas, which would have a restraining effect on rate-sensitive sectors here.

"Liquidity is being drained, monetary stimulus is being drained," said Achuthan, thus "that might be lucky in a sense for the Fed in that it might ease inflationary pressures coming from abroad."

Meanwhile, the Fed's Rocky Mountain retreat from data watching will be brief. Next week brings the July report on the personal consumption expenditures price index excluding food and energy, the Fed's preferred inflation gauge that's been running well above the central bank's 1% to 2% comfort zone.

After that comes the August employment report, the contents of which will probably go a lot further in determining the outcome of the September FOMC meeting than the long-term effects of globalization.