What Measure of Inflation Should a Central Bank Target?

This paper assumes that a central bank commits itself to maintaining an inflation target and then asks what measure of the inflation rate the central bank should use if it wants to maximize economic stability. The paper first formalizes this problem and examines its microeconomic foundations. It then shows how the weight of a sector in the stability price index depends on the sector’s characteristics, including size, cyclical sensitivity, sluggishness of price adjustment, and magnitude of sectoral shocks. When a numerical illustration of the problem is calibrated to U.S. data, one tentative conclusion is that a central bank that wants to achieve maximum stability of economic activity should use a price index that gives substantial weight to the level of nominal wages. (JEL: E42, E52, E58) Over the past decade, many central banks around the world have adopted inflation targeting as a guide for the conduct of monetary policy. In such a regime, the price level becomes the economy’s nominal anchor, much as a monetary aggregate would be under a monetarist policy rule. Inflation targeting is often viewed as a way to prevent the wild swings in monetary policy that were responsible for, or at least complicit in, many of the macroeconomic mistakes of the past. A central bank committed to inflation targeting would likely have avoided both the big deflation during the Great Depression of the 1930s and the accelerating inflation of the 1970s (and thus the deep disinflationary recession that followed). This paper takes as its starting point that a central bank has adopted a regime of inflation targeting and asks what measure of the inflation rate it should target. Our question might at first strike some readers as odd. Measures of the overall price level, such as the consumer price index, are widely available and have been amply studied by index-number theorists. Yet a price index designed to measure the cost of living is not necessarily the best one to serve as a target for a monetary authority. Acknowledgments: We are grateful to Ignazio Angeloni, William Dupor, Stanley Fischer, Yves Nosbusch, the editor Roberto Perotti, and anonymous referees for helpful comments. Reis is grateful to the Fundacao Ciencia e Tecnologia, Praxis XXI, for financial support. E-mail addresses: Mankiw: [email protected]; Reis: [email protected] © 2003 by the European Economic Association This issue is often implicit in discussions of monetary policy. Many economists pay close attention to “core inflation,” defined as inflation excluding certain volatile prices, such as food and energy prices. Others suggest that commodity prices might be particularly good indicators because they are highly responsive to changing economic conditions. Similarly, during the U.S. stock market boom of the 1990s, some economists called for Fed tightening to dampen “asset price inflation,” suggesting that the right index for monetary policy might include not only the prices of goods and services but asset prices as well. Various monetary proposals can be viewed as inflation targeting with a nonstandard price index: The gold standard uses only the price of gold, and a fixed exchange rate uses only the price of a foreign currency. In this paper, we propose and explore an approach to choosing a price index for the central bank to target. We are interested in finding the price index that, if kept on an assigned target, would lead to the greatest stability in economic activity. This concept might be called the stability price index. The key issue in the construction of any price index is the weights assigned to the prices from different sectors of the economy. When constructing a price index to measure the cost of living, the natural weights are the share of each good in the budget of typical consumer. When constructing a price index for the monetary authority to target, additional concerns come into play: the cyclical sensitivity of each sector, the proclivity of each sector to experience idiosyncratic shocks, and the speed with which the prices in each sector respond to changing conditions. Our goal in this paper is to show how the weights in a stability price index should depend on these sectoral characteristics. Section 1 sets up the problem. Section 2 examines the microeconomic foundations for the problem set forth in Section 1. Section 3 presents and discusses the analytic solution for the special case with only two sectors. Section 4 presents a more realistic numerical illustration, which we calibrate with plausible parameter values for the U.S. economy. One tentative conclusion is that the stability price index should give a substantial weight to the level of nominal wages. 1. The Optimal Price Index: Statement of the Problem Here we develop a framework to examine the optimal choice of a price index. To keep things simple, the model includes only a single period of time. The central bank is committed to inflation targeting in the following sense: Before the shocks are realized, the central bank must choose a price index and commit itself to keeping that index on target. 1059 Mankiw and Reis Inflation Target of a Central Bank