Discretionary inflation rules lower welfare losses by 9.4 percent
Targeting discretionary inflation rather than headline consumer price indices reduces monetary policy welfare losses by 9.4 percent, according to a Bank of England study. Discretionary sectors account for 95 percent of cyclical output drops but only 14 percent of price swings.
Where interest rates actually bite
Euro area data show a disconnect between the sectors driving inflation and those transmitting monetary policy.
Discretionary sectors account for 95 percent of consumption contractions and 96 percent of employment drops in recessions, but generate only 14 percent of inflation fluctuations.
In contrast, necessity sectors drive 86 percent of price movements.
Discretionary industries also employ more hand-to-mouth workers, averaging 17.5 percent compared with 8.5 percent in necessity sectors.
Contractionary policy shocks reduce discretionary consumption by up to 80 basis points, while necessity prices drop twice as much as discretionary prices.
Bridging the gap to Ramsey policy
The researchers build a two-sector New-Keynesian model featuring non-homothetic demand and heterogeneous labor markets.
Discretionary prices also adjust less frequently in micro data, with a monthly change probability of 10.1 percent compared to 14.9 percent for necessities.
Calibrated simulations show that a discretionary inflation rule closes about two-thirds of the welfare loss gap between a standard headline CPI rule and the optimal Ramsey policy under commitment.
Measurement is not stabilization
Headline CPI works well for measuring living costs but fails as a guide for interest rate stabilization.
Raising rates in response to supply-driven necessity shocks needlessly punishes vulnerable workers in interest-sensitive industries.
Central banks should unbundle their communication target from their operational reaction function.
Source: Inflation composition and monetary stabilization
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