The Fed’s ability to set the short-term interest rate independently of foreign financial conditions depends critically, of course, on the fact that the dollar is a freely floating currency whose value is continuously determined in open, competitive markets. If the dollar’s value were fixed in terms of another currency or basket of currencies, the Fed would be constrained to set its policy rate at a level consistent with rates in global capital markets. Because the dollar is free to adjust, U.S. interest rates can differ from rates abroad, and, consequently, the Fed retains the autonomy to set its federal funds rate target as needed to respond to domestic economic conditions.

Recent research suggests another possibility, which is that U.S. monetary policy actions may have significant effects on foreign yields and asset prices as well as on domestic financial prices. For example, changes in U.S. short-term interest rates seem to exert a substantial influence on euro area bond yields and appear to have a strong effect on foreign equity indexes as well.  In contrast, the effects of foreign short-term rates on U.S. asset prices appear to be relatively weaker. These cross-border effects of policy, and their asymmetric nature, are somewhat puzzling. One would expect a more symmetric relationship between the United States and the euro area, for example, as the two regions are of comparable economic size. It will be interesting to see if these relationships persist.

Rogoff (2003) provides an alternative theory of how globalization may affect the central bank’s inflation objective. He argues that deregulation and international integration have led to more flexible prices, so that any attempt by a central bank to stimulate the real economy by allowing inflation to rise unexpectedly will be less effective than it would have been in the past. Because central banks have less incentive to create unexpected inflation, their promises to keep inflation low are more credible, which in turn reduces the cost of keeping inflation low. Accordingly, in Rogoff’s analysis, globalization has led monetary authorities to maintain lower long-term inflation rates. A criticism of this story is that it implies that the Phillips curve is steeper today than in the past (that is, that inflation is more sensitive to slack in the economy), a prediction that does not accord with most empirical studies.

[I]mported goods make up only part of what people consume, and so the effect on overall inflation is less than the deceleration in the prices of imports alone. Typical estimates of the short-term effect on the overall inflation rate of less-rapid increases in the prices of imports stemming from trade with China are in the neighborhood of 0.1 percent or less per year--a discernable but certainly not a large effect.

Recently, however, several researchers affiliated with the Bank for International Settlements (BIS) have reported results favorable to the global output gap hypothesis (Borio and Filardo, 2006). Using data for sixteen industrialized countries (plus the euro area) for 1985-2005, they found significant effects of the global output gap on domestic inflation rates--indeed, effects that were generally larger than those of domestic output gaps and that were rising over time. This provocative result has in turn been challenged by Federal Reserve Board researchers, who find that the empirical support for a role for the global output gap does not survive modest changes in the way the data are analyzed. As domestic output gaps are difficult to measure, even with the benefit of hindsight, it is perhaps not surprising that measuring and assessing the effects of a global output gap have proved contentious.

The competition fostered by trade should also promote productivity growth, reducing growth in costs and making the attainment of low inflation easier. That productivity growth is linked to the intensity of competition is plausible, and more-rapid productivity growth seems to help to explain the slowing of inflation in the United States in the mid-1990s. However, the fact that most other industrial countries did not experience the same increase in productivity growth as the United States during that period, even as they became more open to trade, suggests that the relationship between productivity and trade may be complex.

We look down the vector of inflation rates and with the exception of Venezuela and a couple of other countries, they're all single digit, indeed clustered in the area of 1% to 7%, annual rate. I don't recall ever seeing that. I'm too much aware of the fact that we always had some two or three economies which were verging on hyper inflation or were in very serious difficulty. We don't have that at this particular stage. And similarly because of that we have nominal long-term interest rates all in single digits. What this essentially tells us is there's an integration in the world economy, which I've argued elsewhere is a consequence of the very dramatic impact of the fall of the Soviet Union and its economic consequences in creating a very large increase in the number of previously low cost, somewhat educated workers insulated behind central planning being opened to the competitive markets, the effects of which have been extraordinary. In a sense we are on the way to, over the longer run, doubling the size of the labor force which is working in international, competitive markets. That has brought world unit labor costs down, brought inflation down and interest rates down.

We look down the vector of inflation rates and with the exception of Venezuela and a couple of other countries, they're all single digit, indeed clustered in the area of 1% to 7%, annual rate. I don't recall ever seeing that. I'm too much aware of the fact that we always had some two or three economies which were verging on hyper inflation or were in very serious difficulty. We don't have that at this particular stage. And similarly because of that we have nominal long-term interest rates all in single digits. What this essentially tells us is there's an integration in the world economy, which I've argued elsewhere is a consequence of the very dramatic impact of the fall of the Soviet Union and its economic consequences in creating a very large increase in the number of previously low cost, somewhat educated workers insulated behind central planning being opened to the competitive markets, the effects of which have been extraordinary. In a sense we are on the way to, over the longer run, doubling the size of the labor force which is working in international, competitive markets. That has brought world unit labor costs down, brought inflation down and interest rates down.

Friedrich Hayek had long ago advocated permitting greater competition among currencies, arguing that there would be a race to the top rather than a race to the bottom.  Regardless of what one might think of Hayek's policy proposals, technological change in a globalized and competitive marketplace, I believe, has increased competition among currencies issued by central banks.

...

In a nutshell, I believe that the factors of globalization, deregulation, and financial innovation, arising partly in response to episodes of high inflation, have effectively eroded the central bank monopoly on the provision of monetary services and have enhanced global competition among currencies. These changes have, in turn, altered the incentives for central banks to behave badly and for finance ministries to use central banks as "piggy banks" to finance their fiscal policies.

Globalization in combination with advances in technology, especially communications technology, leads to similar patterns. At the upper end, it has boosted demand for those who have the skills to manage large, complex, global operations. In contrast, an increasing share of domestic jobs in the middle of the wage spectrum has experienced lower demand because companies can now look all over the world for workers able to perform computer programming tasks, communications tasks, and similar jobs—even medical services. At the same time, such outsourcing is far less feasible for manual jobs and for service jobs that require face-to-face interactions and lie at the low end of the wage distribution.

In the world of 2000, the notion that Mexico would issue a 30-year local currency bond and pay just a few basis points over a U.S. Treasury was unthinkable.

Cross-border flows of real and financial capital have also increased dramatically—a reflection of the recent notable reduction in the degree of home bias in capital markets.

Harvard economist Ken Rogoff and others have pointed out that to the extent that globalization increases the degree of competition, it can reduce the “inflationary bias” or, to put it differently, it can strengthen the anti-inflation credibility of a central bank. By inducing greater price flexibility, competition lowers the short-run gains to output from an unanticipated inflation, and thus permanently reduces the incentives for a central bank to try to exploit those gains. The improved credibility of the central bank’s commitment to keep inflation low and stable should, in turn, allow it to deliver better inflation outcomes with fewer short-run costs to economic growth and employment.

Although economic globalization has come a long way, in one particular dimension--finance--it is very far from complete...

We have seen that the repression of the financial system is a great obstacle to economic growth and the reduction of poverty in poorer countries...

Government is often the primary source of financial repression in developing countries. Strong property rights, a crucial element in financial development, severely constrain a government's ability to expropriate land, factories, or ideas whenever it wants to profit from them.

Indulge me for a moment here. Let’s suppose that this substantial economic machine we know as Texas changed its relationship to the U.S. in one and only one way: by establishing its own free-floating currency and independent central bank with the same mission as the Fed—except just for Texas. I know what some of you are thinking: The loonie is already spoken for, so let’s call our imaginary Texas currency the “burrito” and back it with the full faith and credit of the government in Austin, a government, incidentally, that is currently running a budget surplus.