BoE paper: the index that tracks living costs may not be the one to target
Serguey Asael Shinder2 min readA Bank of England staff working paper published on 25 September questions an assumption built into most inflation targeting: that the price index measuring the cost of living is also the right one to guide monetary policy. The authors - Michele Andreolli, Natalie Rickard, Paolo Surico and Chiara Vergeat - start from the observation that every inflation index is an aggregation rule, and ask when the rule that measures purchasing power is also the one that should steer the policy rate.
In standard New Keynesian models the two coincide. The paper shows they diverge when the sectors generating price movements differ from the sectors through which interest rates act on demand, income and costs. Using new euro-area data, the authors find such a mismatch: discretionary sectors are where quantities move with the cycle and where many hand-to-mouth workers are employed, while necessity sectors account for much of the variation in inflation. After a contractionary policy shock, discretionary consumption and employment adjust the most, but necessity prices respond more.
In a two-sector model built to match those facts, the best simple policy rules put almost all their weight on discretionary inflation. Reacting to necessity inflation, the authors argue, uses the discretionary sector as the adjustment margin for price movements in sectors where policy has little effect on quantities. With the stickier discretionary prices observed in the euro area, a rule based on discretionary inflation closes about two thirds of the welfare gap between a CPI rule and the optimal policy. The paper's closing line sums it up: expenditure weights need not be stabilisation weights.
What it means
Staff working papers are research in progress, not Bank policy, and this one is estimated on euro-area data. Its relevance is the question it puts on the table at a time when energy and food - necessities - are again pushing up headline inflation in the UK and elsewhere.
The argument does not say necessity inflation does not matter to households; it plainly does, and the CPI remains the measure of their cost of living. It says that raising rates in response to it works mainly by squeezing a different part of the economy. That is a precise way of stating a trade-off central bankers often describe loosely when they talk about "looking through" supply shocks.