Cost growth is subdued in many economies, reflecting continued slack as illustrated by the comovement of an estimated world output gap with world core inflation – a glimpse of a “global” Phillips curve (Chart 8). 15 The impact of these forces on domestic inflation depends crucially on movements in the exchange rate. In the face of purely nominal shocks, for example if foreign monetary policy were excessively tight, disinflationary impulses from abroad could be expected to be dampened by an exchange rate depreciation acting as a buffer. But today, in the UK, the exchange rate is reinforcing disinflationary impulses from abroad, with sterling appreciating by around 20% since early 2013. While the appropriateness of moves of this scale in sterling and of a similar magnitude in the dollar may be subject to debate, directionally they suggest real forces at work. One possible driver could be the speed of adjustment of different economies to the financial crisis, with those more flexible economies that took the more decisive action to fix their financial systems seeing the fastest recoveries and largest appreciations. For very open economies like the UK, with a high proportion of imports invoiced in foreign currencies, persistent, sizeable moves in exchange rates matter for the inflation outlook.
After adjusting for unconventional policy there’s greater monetary policy divergence than implied by a simple eyeballing of the currently highly synchronised global rates cycle. And there remains the prospect of a further widening. In other words, domestic economic conditions – conditions affected by domestic monetary policy – still very much matter. None of this diminishes the considerable challenges of returning inflation to target in the face of global developments. There are profound secular and cyclical disinflationary forces at work in the global economy, and for economies like the UK their impact is being reinforced by exchange rate movements which will drag inflation down further at the policy horizon. Moreover, as events of the past few weeks have reminded us, a variety of global factors can affect global financial conditions and influence the neutral rate of interest. Central banks must take these Disparate Confounding Dynamics (DCDs) into account when setting policy. 2 Even for those economies with the strongest recoveries and the best functioning financial systems, they mean that the policy rates consistent with returning inflation to target will likely need to rise in a gradual fashion and to a limited extent despite robust domestic demand and firming domestic costs. For the UK at least, global DCDs influence but do not dictate policy. 1  Subramanian, A and Kessler, M (2013), “The hyperglobalization of trade and its future”, Global Citizen Foundation working paper 3, June.