Quelle Surprise! Imports Lowering Inflation and Complicating Fed’s Job

A good paper at VoxEU reaches a conclusion that seems expected, yet has been contested in academic research, namely, that imports have lowered US inflation. As we have discussed in other posts, this has far more important policy implications than obvious at first blush. The Fed has been looking at inflation as strictly a domestic phenomenon. Not allowing for the impact of the trade sector has led the central bank to set unduly low Fed fund rates.

Authors Raphael Auer and Andreas Fischer found that the effect of imports was significant, reducing producer prices by 2%. In addition, they found that one of the channels for this outcome was via higher productivity in the sectors experiencing import competition, which they defined as goods with significant labor costs. They did not find evidence that these productivity improvements came from lowering incomes (although they may have prevented gains), which meant they resulted either from working smarter or working harder.

From VoxEU:

Research using a novel empirical technique suggests that import competition from low-wage countries dampens US producer price inflation for manufactured goods by more than 2 percentage points annually.

Have cheap imports from low-wage nations held down inflation in rich economies? Contrary to what customers at Wal-Mart, Toys”R”Us, or Best Buy observe every day, the academic literature has found surprisingly little evidence that trade with China and other poor, yet rapidly industrializing nations have had a large impact on prices in the rest of the world.
Is China exporting deflation?

In an influential study, Stephen Kamin, Mario Marazzi, and John Schindler (2006) ask whether China is “exporting deflation” to the United States, a question answered with a definitive no. Imports from China, they find, have a much smaller effect on US import prices than expected and no detectable impact on US producer prices. Related studies for Austria, Norway, Japan, the United Kingdom, and other countries report similar findings.

Identifying the effect of import competition on prices is difficult, however, due to the problem of distinguishing supply and demand shocks. For example, winter jackets in US got cheaper when quotas on imports from China and India were removed. Nevertheless, if demand was simultaneously increased by a cold winter, the equilibrium price would not necessarily decrease. Yet it is exactly the supply side that we must identify if we want to know how much dearer jackets would have been without the cheap imports. Because current studies cannot identify the supply and demand shocks that cause changes in trade flows, they cannot establish the true effect of import competition on prices and inflation.

The empirical literature of international trade is well aware of the simultaneity of supply and demand and, therefore, utilizes one-time tariff reductions to identify the causal effect of trade; see for example Daniel Trefler’s (2004) work on the effect of NAFTA on Canadian industry. Unfortunately, large tariff reductions are rare and the literature has yet to find a suitable event that led to a substantial increase of imports from low-cost producers.1\

In a recent study, we develop a new methodology to establish the causal effect of imports from nine low-income countries on US inflation (Auer and Fischer 2008). The nine countries we examine are China, Brazil, Indonesia, India, Malaysia, Mexico, Philippines, Thailand, and Vietnam. In 2006, these nine low-income countries accounted for imports worth more than 600 billion dollars, equivalent to one third of all US imports or 5.5% of US GDP (see Figure 1).

At the heart of our argument lies the simple observation that when labour abundant nations grow, their exports tend to increase most in sectors that intensively use labour as a factor of production. US imports originating from low-income countries are highly concentrated in labour intensive sectors such as textiles or toys (see Figure 2).2 In our study, we document that this relation also holds in terms of changes. If a low-income country’s output capacity grows, its exports increase most in labour intensive sectors.

This observation gives us an empirical lever on supply-side changes that does not depend upon the price. With this lever, we can separate out the supply and demand effects (i.e. it gives us an instrumental variable).

Building on the fact that the change in imports at the sector level is related to the sector’s labour intensity, we then estimate the effect of import competition from low-wage countries on US producer prices in a framework that controls for both sector-specific trends and aggregate shocks. When the nine low-income countries grow above trend, US imports in labour intensive sectors increase relative to US imports in capital intensive sectors. This difference in the reaction of sectoral import volume to low-income country growth is utilized to establish the effect of import volume on US prices.

In a panel covering 325 manufacturing industries from 1997 to 2006, we find that trade with low-income countries has had a profound impact on US relative prices. For example, we find that if the US market share of low-income countries increases by 1%, prices in the sector decrease by between 2% and 3%. We next decompose this price-dampening effect of imports into the contributions stemming from productivity growth, mark-up reductions, and cost changes.

By and large, the dominant channel through which imports have affected US industry is via inducing sectoral productivity growth. In our estimations, a one percentage point increase in the US market share of low-income economies is associated with an increase in productivity by around two percentage points. Decreasing mark-ups can explain the remainder of the drop in prices. Surprisingly, we do not find any evidence that imports affect the cost of intermediate goods used in production or reduce the wages of unskilled workers.

The conclusion of our study is that globalization has had a more profound impact on US relative prices and productivity than is commonly assumed. Our results, however, have to be interpreted with care when making statements on the effect of low-income countries on aggregate US inflation and productivity. Due to the difference-in-difference type identification, our methodology abstracts from factors such as the increase in global raw material prices that growth in emerging economies has brought about. Given these limitations, a rough estimate is that from 1997 to 2006, imports from low-income countries reduced the US PPI inflation rate in the manufacturing sector by about two percentage points (each year). China accounts for over half of the total effect.

While manufacturing prices make up only a fraction of the PPI inflation index and producer price inflation is passed through only imperfectly to consumer prices, the effect of imports from emerging economies should not be neglected and needs to be addressed in monetary policy decisions.

The overall effect of relative price shocks on aggregate inflation ultimately depends on the response of the central bank (see for example Mishkin 2007 or Trichet 2008). Imports from low-income countries had a dampening effect on inflation in the booming US economy of the last decade, thus allowing – among other factors – monetary policy to be relatively loose. At this juncture, core inflation has finally caught up and may stay elevated for a prolonged period: monetary tightening will crowd out cheap imports from low income countries and, consequently, have a smaller effect on inflation than would be the case in the absence of trade.