Abstract
During the second half of the 2000s, the world experienced a rapid and substantial rise in commodity prices. This shock posed complex challenges for monetary policy, in particular because of the significant increase in food and energy prices, and the repercussions they had on aggregate inflation measures. This paper discusses the role of commodity price shocks (CPS) in monetary policy in the light of recent episodes of such shocks. It begins by discussing whether monetary policy should target core or headline inflation, and what should be the role of CPS in setting interest rates. It is argued that there are good reasons to focus on headline inflation, as most central banks actually do. Although core inflation provides a good indicator of underlying inflation pressures, the evolution of commodity prices should not be overlooked, because of pervasive second-round effects. This paper reviews the evidence on the rise of inflation across countries and reports that food inflation, more than energy inflation, has relevant propagation effects on core inflation. This finding is particularly important in emerging market economies, where the share of food in the consumer basket is significant. The evidence also shows that countries that had lower inflation during the run up of commodity prices before the global crisis had more inflation in the subsequent rise after the global crisis, suggesting that part of the precrisis inflationary success may have been because of repressed inflation. This paper also discusses other factors that may explain different inflationary performances across countries.
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Notes
For details on managing the copper price boom in Chile, see De Gregorio and Labbé (2011).
See, for example, Medina and Soto (2005) and Batini and Tereanu (2010).
The output gap is the difference between current output and full-employment output, so an increase in the gap means an increase in economic activity.
The sample is based on data availability at the MEI-OECD database. The advantage of these data is that classification is the same across countries, but it only includes OECD countries. The data are available at http://stats.oecd.org/index.aspx?DatasetCode=MEI_PRICES.
For a derivation of this approximation, see Woodford (2003) and Galí (2008).
See, for example, the debate between Paul Krugman and Lorenzo Bin Smaghi reported in Lenza and Reichlin (2011).
This type of models can also be used to define the optimal monetary policy strategy, for example, whether a strict inflation target is preferable, but in this discussion I will focus on flexible inflation target regimes.
Indeed, in Spanish the translation of “core inflation” is “inflación subyacente” (underlying) rather than “inflación central.”
There are differences in the reported weights across different sources, which may be due to the exact index being used or the date when the weight is reported. Here I use 2010 weights for national CPI according to MEI-OECD.
There are some countries that exclude the mortgage components and taxes from the index to target, in order to isolate inflation from monetary and fiscal policy measures. This has been the case during some time in South Africa, Sweden, and the United Kingdom. The discussion in this section does not address those issues, but as the indices have been harmonized, most countries have eliminated those corrections, which in the past created sharp swings in headline inflation.
The emphasis these countries place on core inflation had led some classifications to assume they target core inflation, which is not the case.
I will ignore that weighting is exponential, which does not affect the discussion. In addition, according to Equation (6), if the covariance between core and commodities inflation is positive (most likely), headline inflation will be more volatile than core inflation. In terms of designing an inflation-targeting regime, the policy horizon of headline inflation targeting should be longer than that of core inflation targeting (De Gregorio, 2007).
Since I am ignoring dynamics, one should think this is in a time horizon of, say, one year, otherwise the second-round effect should consider lagged inflation.
Indeed, the results reported in Killian (2009) show that effects on activity would be limited, but the inflationary effects should be higher. However, the rise in inflation did not take place.
Gelos and Ustyugova (2012) also survey other recent empirical evidence.
It excludes perishable goods (fresh fruits and vegetables), gasoline, fresh meat and fish, indexed prices, regulated public utility rates, and financial services.
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Additional information
Prepared for the Conference on Policy Responses to Commodity Price Movements, organized by the IMF and the Central Bank of Turkey, April 2012. Part of this paper was written while the author was a visiting scholar at the Research department of the IMF, and he is very grateful for its hospitality. The author is also very grateful for discussions with and suggestions from Larry Ball, Pierre Olivier Gourinchas, Thomas Helbling and Ayhan Kose, and conference participants, as well as for the valuable comments and assistance from Felipe Labbé.
*José De Gregorio is professor at the Economics Department of the Universidad de Chile. He was governor of the Central Bank of Chile, and previously served as Minister of Economy, Mining and Energy.
This is, for example, the case of soy beans in Argentina, copper in Chile, or oil in Nigeria.