How important is the financial sector to price indices in an inflation targeting regime? An empirical analysis of the UK and the US

Abstract

This paper investigates whether there are benefits in terms of higher economic stability from incorporating stock prices into the price index targeted by the central banks. It also looks into the question of whether central banks should use stock prices as a component of the output stability index and how the index can be constructed. An optimization technique is employed to estimate weights for the various sectoral prices. The obtained weights, which depend on sectoral parameters, differ from those used in the construction of the consumer price index, CPI. Using data from the UK and the US, our analysis demonstrates that in comparison to the CPI, our measure of inflation leads to a higher output stability. Thus, in an inflation-targeting monetary policy environment, it is important to adopt a broader inflation benchmark than the CPI for the general macroeconomic stability.

Seeking Price and Macroeconomic Stabilisation in the Euro Area: The Role of House Prices and Stock Prices

“…The benchmark typically applied by monetary authorities for inflation targeting is the consumer price index (CPI). However, existing literature argues that the CPI covers only the current cost of living and does not include expected inflation (Alchian and Klein, 1973;Goodhart, 2001;Mankiw and Reis, 2003;Kent and Low, 1997;Shiratsuka, 1999;Shah, 2013 andAhmad, 2017). A central bank faces the problem of how to choose an appropriate price index as a measure of inflation which would help to reduce output instability.…”

“…The ESI can be described as: Mankiw and Reis (2003) derived a two-sector theoretical analysis of the central bank's problem. Later, Charemza and Shah (2013) and Shah and Ahmad (2017) extended further the theoretical analysis for a four-sector setting and derived its algebraic solution 9 . As mentioned above, the central bank's objective is to promote economic stability by choosing a target price index, given the constraints imposed by the price-setting procedure.…”

“…Additionally, sectoral idiosyncratic shocks can be correlated with the output gap, causing identification problems. To address these issues, rather than Mankiw and Reis, we follow Charemza and Shah (2013) and Shah and Ahmad (2017) and apply a Vector Autoregressive (VAR) model to Börse, Dow Jones & Company and SWX Swiss Exchange. The most important feature of this index is that it brings together the 50 largest companies among the 19 supersectors in terms of market capitalisation in eleven member countries (Austria, Belgium, Germany, Finland, France, Italy, Ireland, Luxembourg, Netherlands, Portugal and Spain).…”

“…ic indicators in most EA countries. We follow the methodology proposed by Charemza and Shah (2013) and extended by Shah and Ahmad (2017) to estimate the sectoral parameters and target weights for the ESI, where the aim of the central bank is to obtain greater economic stability. Firstly, the sectoral parameters are set or estimated in order to compute the target weights for the ESI.…”

How should Central Banks Respond to Non-neutral Inflation Expectations?

“…Many suggest that stabilizing inflation in the sticky-price sector is a better policy and that the flexibleprice sector can be ignored, arguing that in sticky-price sectors, price setters are slow to update and do not react immediately to economic changes (Aoki 2001;Mankiw and Reis 2002;2003;Benigno and Benigno 2004). Once the aim of stable inflation is established and credibility is enhanced, the monetary policy regime should be concerned with minimizing the variability of growth (Shah and Ahmad 2016).…”