One of the most striking events of the past two decades is the remarkable decline in inflation rates around the world. This decline has taken place in both developed as well as developing economies. Not only did the level of inflation fall -- there were also significant changes in the relationship between inflation and measures that have traditionally helped forecast inflation. These developments coincided with a pick up in the pace of global economic integration.

Many commentators cite the increase in the imports of low-cost goods from countries such as China and India as having directly held down the rate of increase of the imported-goods component of the consumer price index and, thus, the rate of increase of the overall index. This direct effect on CPI inflation has risen over time as the import share of household spending has increased. Beyond this effect, falling prices for imported materials have reduced production costs, thereby indirectly restraining the growth of prices of domestically produced goods and services.

A recent paper by Ihrig et al (2007) examines this hypothesis for 11 developed economies. They found only weak evidence that import prices affect home inflation in these countries. There are two plausible explanations for this. A decline in import prices as a result of globalisation is a relative price shock. Trade with China and India reduces the relative prices of traded goods. As a result, people now have more to spend on non-traded goods, thereby increasing the demand and, hence, prices of these goods. This nullifies the effect of a decline in imported inflation on the overall index.

Furthermore, not all aspects of globalisation and trade reduce inflation. For example, globalisation has been associated with strong growth in some large emerging-market economies, notably China and India, and this growth likely has contributed to the recent surge in the prices of energy and other commodities. When the offsetting effects of globalisation on the prices of imported goods are considered together, there seems to be little basis for concluding that globalisation has significantly impacted inflation.

A sizeable literature has also estimated the responsiveness of inflation to the domestic output gap -- a variable that has traditionally helped forecast inflation. There is robust evidence throughout the industrial world that this relationship has become considerably weaker in recent years ie, inflation responds much less to measures of domestic resource utilisation than previously. As a result, inflation has become much harder to forecast.

Why has this happened? A plausible explanation for this is that the strengthening of competition in the product market as a result of globalisation has limited the extent to which domestic firms can pass on an increase in costs to the consumer through increased prices. As a result, the story goes, domestic output gap has become less important in predicting inflation. Has globalisation made domestic inflation more sensitive to foreign events?

The Ihrig et al (2007) paper empirically evaluates whether inflation has become more sensitive to global factors and less sensitive to domestic factors. If the link between global factors and domestic inflation is strong, resource utilisation in the rest of world should have an impact on domestic inflation. The paper finds that the estimated effect of foreign output gaps on domestic consumer price inflation is generally insignificant.

If so, why has inflation become less sensitive to domestic output gap? The rising credibility of monetary policy has been cited by various researchers as an important explanation for this. In particular, a strong commitment by central banks to maintaining a low and stable rate of inflation has helped anchor inflation expectations, which dampens movements in actual inflation.

For example, consider an adverse supply shock. The increases in the price of energy that we experienced recently drive inflation and output in opposite directions. If inflation expectations are well anchored, the central bank is free to pursue expansionary monetary policy to counteract the increased slack in the economy, with the knowledge that such a policy would not lead to a sharp rise in inflation. Indeed, the stability of output that we have witnessed in recent decades is consistent with this interpretation.

Nevertheless, it is fair to say that a number of factors have helped monetary authorities achieve their objective of low and stable inflation. Whether the greater stability experienced during the recent past reflects globalisation or better luck (ie, smaller shocks) is the subject of much ongoing research. Therefore, disentangling the relative importance of competing explanations remains an important challenge.

The author is senior economist, Crisil.