UK Inflation Target Should Be Prices Of Goods Produced Not Goods Consumed

The Consumer Price Index (CPI) is the wrong measure of inflation for the Bank of England to target, according to new research by Professor Simon Wren-Lewis and colleagues.

Writing in the June 2006 issue of the Economic Journal, they argue that the UK''s monetary policy-makers should instead focus on a measure of output price inflation – that is, changes in the price of goods produced rather than goods consumed.

The study reviews two arguments for a change of focus. The first suggests that if policy follows simple rules that relate interest rates to consumer price inflation, then instability may result because of the impact of interest rates on the exchange rate.

To take one simple example, suppose that UK inflation was expected to increase in a year''s time. The foreign exchange market would anticipate higher interest rates in the future, leading to an appreciation in sterling today. This appreciation would lower import prices and tend to reduce consumer price inflation. If the Bank of England followed a simple CPI-based rule, they would cut interest rates, which would be a quite inappropriate response to higher expected inflation.

A number of recent studies suggest that this danger of instability may occur in a variety of situations. Wren-Lewis and his colleagues look at a simple example, and show that a monetary policy rule based on CPI inflation may lead to generic instability in an economy that is relatively open, and where the monetary policy rule is quite aggressive. This danger does not occur if the monetary authority''s policy rule is based on output price inflation rather than CPI inflation.

These problems can be dealt with if policy avoids following a fixed rule. This leads to the second argument against targeting CPI inflation, which is based on welfare.

There are a number of reasons why inflation is costly, but one that has been the focus of much recent research is that inflation generates movements in relative prices, which in turn generate changes in output and employment among industries that are costly for workers. The higher the rate  of inflation, the greater this disruption in the pattern of employment and production.

The key insight is that this cost of inflation comes from the production side of the economy and not from consumption. It is therefore captured by looking at a measure of inflation based on output rather than the CPI. This research implies that the sole objectives of monetary policy should be to minimise output price inflation and the output gap.

If such policy were to be followed, it would mean that the exchange rate had no place in the objectives of benevolent monetary policy makers. (Here it is important to note that we are talking about policy objectives, and not the means used to achieve these objectives.) These researchers argue that this goes too far.

They suggest why exchange rate ''noise'' might generate a potential role for the real exchange rate in influencing policy-makers'' objectives, alongside familiar concerns about inflation and the output gap. But this exchange rate objective is in the form of a real exchange rate gap, which has similarities to deviations from John Williamson''s concept of a ''fundamental equilibrium exchange rate''. It does not justify concern about CPI inflation. As a result, the welfare-based argument in favour of targeting output price inflation rather than CPI inflation remains robust.

''Should Central Banks Target Consumer Prices or the Exchange Rate?'' by Tatiana Kirsanova, Campbell Leith and Simon Wren-Lewis is published in the June 2006 issue of the Economic Journal.