Hamish McRae: Globalisation: how the new shift of power is affecting inflation

The price of raw materials reaches new "highs"; the price of goods in the shops falls relentlessly. The reason in a word: globalisation.

The fact that the two huge and rapidly growing economies of China and India are now pretty fully integrated into the world economy, plus the end of the Soviet empire, has changed the global relationship between costs, wages and prices. Until about 10 years ago the growth of international trade was mainly driven by developed countries buying and selling more from each other. That was the whole idea behind the Common Market/ European Union. By creating a common market within Europe, countries would be better able to specialise and the economies of scale would drive growth - as indeed it turned out to be.

True, there were new entrants into the developed world markets, but these were relatively small Asian countries, specialising in a narrow range of electronic goods. That changed specific industries but it did not change the general balance of the global market economy. The rise of oil prices in the 1970s and 1980s did change things much more, shifting power for a while away from the developed world to the raw materials producers. But the price fell back and power shifted back.

The new shift of power is both further reaching and more durable. It also brings benefits to a much larger proportion of the world's population than the previous rich-trading-with-rich growth of international trade. But because we are still in the quite early years of the process there is not a huge amount of analytical work on the subject. That is why the International Monetary Fund's latest World Economic Outlook deserves a welcome, for it devotes two sections on all this: one on the impact of the oil price rise on global imbalances, the other on relationship between globalisation and inflation.

As far as the first is concerned there is at least a template: previous oil shocks.

As you can see from the first graph, the oil price is still in real terms lower than it was in the early 1980s. Nevertheless it has still led to a surge in the revenues of the oil exporting nations. In the view of the IMF, this price rise seems more likely to be durable.

At the moment a large part of the additional income is being saved, though just in what instruments or in which countries is most unclear. Apparently the data on the financial flows is very bad. We know money is being saved and we know some of it must be going into US assets, but the flows cannot be tracked in detail.

Insofar as oil revenues are spent, however, we do know that oil exporters are buying a smaller proportion of US goods than they did in the 1970s, with the effect that the US trade deficit is larger than it otherwise would have been. Thus the oil price rise since 2003 has increased the US current account deficit by 1 per cent of GDP.

The IMF comments that in the past, current accounts have adjusted relatively quickly to oil shocks but this time the adjustment may be slower. That is partly because the world financial situation is more stable: inflation is lower and markets deeper and more confident. So there is less upward pressure on interest rates, which would force a more rapid decline in demand. It is also because oil exporters are being more careful about increasing their spending - indeed, since most oil exporters are relatively poor, this is a great development opportunity for them.

The paper is looking specifically at oil as a raw material but similar conclusions would flow from the more general rise in commodity prices. Yesterday, copper reached a record $8,000 a ton. But if globalisation (more specifically the rise of Chinese demand) has fuelled a commodity boom, it has also cut the price of finished goods. The second feature in the World Economic Outlook looks at the way in which globalisation has affected inflation in the developed world.

As you can see from the next graph, developed countries have moved, as far as goods are concerned, from a world of inflation to a world of deflation. Some have moved further than others. The country most open to Chinese imports, the US, has seen a faster decline in the price of goods than Germany or Japan, which import less. But then neither Germany nor Japan has the balance of payments problem of the US and one has to ask whether the decline in US prices, propelled by cheap imports, is sustainable. Maybe a sharp fall in the dollar, which would increase the price of imports, is already taking place. Yesterday the dollar was at a one-year low against the euro.

What is very clear, though, is the divergence between goods inflation (and now deflation) and services inflation. The final graph shows this gap between the two. In most countries inflation in services remains quite strong. The gap between goods deflation and services inflation is much wider in the UK and US than in Germany and Japan. That is partly a function of goods deflation being greater in the US and UK, but it also reflects the lower downward pressure on prices in services (which are largely non-traded) and goods (which are widely traded).

To put the point another way, globalisation holds down the price of goods but not of services, or at least not yet.

The IMF looks at a number of other aspects but its broad conclusions are as follows. In the medium term, global inflation is determined by the main policy anchor, such as central bank inflation targets (or in the case of the US, inflation policy, since there is no explicit target). While the direct effect of globalisation in holding down prices is quite small, there have been times when spare capacity in Asia has pushed down inflation in developed countries by up to 1 per cent, which is quite a lot. It also exerts an indirect downward pressure on inflation though its impact on wage rates in developed countries.

Unsurprisingly some of the biggest effects have been in relative prices: a sector exposed to international competition will see a sharp fall, while one not exposed will not. The IMF notes that some service industries have been affected, as well as manufacturers.

And the upward pressure on commodity prices - should we worry? Well, the IMF thinks we should. It suggests there is a danger that this will seep through into inflation more generally.

The moral of all this is that globalisation itself has not rid the world of inflation. But it has had a big impact on relative prices and will continue to do so. So the pressure remains on countries to figure out things they can do that other countries cannot do just as well on much lower wages.

Meanwhile I suppose we should continue to worry about the oil price and acknowledge that the commodity boom may yet have some way to run - thoughts, of course, echoed by the authors of the Bank of England Inflation Report.