Target what you can hit

The analytical chapters of the WEO is out. The 3rd chapter address the following questions;

-What are the effects of international commodity price swings on inflation across a variety of economies? What economic factors influence these effects?

-What is the appropriate monetary policy response to commodity price shocks? In particular, how does the approach of targeting underlying inflation rather than headline inflation perform in terms of delivering macroeconomic stability in different types of economies? Should central banks respond to persistent commodity price shocks any differently than to one-time shocks?

-Finally, what are the implications for monetary policy in today’s environment, with excess demand pressures in some emerging and developing economies and economic slack in advanced economies?

These are the main findings of the chapter:

-Food price shocks tend to have larger effects on headline inflation in emerging and developing economies than in advanced economies. On a related note, because medium-term inflation expectations are weakly anchored in many emerging and developing economies, food price shocks have larger effects on inflation expectations in these economies.

-The measure of inflation used to define a central bank’s target matters because of its effect on the central bank’s credibility. In economies with low initial monetary policy credibility and high food shares in the consumption basket, focusing on underlying inflation—that is, a measure that reflects the changes in inflation that are likely to be sustained over the medium term—rather than on headline inflation, makes it easier to build credibility. The reason is that it is harder to hit headline inflation targets when commodity prices are volatile. Higher credibility, in turn, leads to better-anchored inflation expectations and lower volatility of both output and headline inflation.

-The desirability of setting and communicating monetary policy based on a measure of underlying inflation depends on the relative importance of headline inflation and output to a country’s welfare. A headline framework can lower the volatility of headline inflation, but at the cost of significantly higher volatility in output (and hence in household income).

-Finally, in economies where central bank credibility is still limited and the share of food in consumption is high (as in a number of emerging and developing economies), a food price shock is likely to have even larger second-round effects and require a more aggressive policy response when excess demand pressures are high and inflation is running above target. This assumes that the economic costs rise as the gap increases between actual inflation and the target. In contrast, in economies where the central bank’s credibility is strong, where food accounts for a low share in consumption baskets, and where there is substantial economic slack (as in major advanced economies today), the monetary policy tightening required to stabilize inflation is more gradual.