Bank of England working paper finds optimal response to commodity price shocks depends on whether economies import or export commodities

The Bank of England has published a staff working paper that argues the welfare-optimal monetary policy and exchange rate framework depends on an economy’s commodity exposure. In the authors’ model, stabilising domestic prices is optimal for commodity exporters, while economies that use commodities as production inputs should largely look through both the direct and indirect effects of commodity shocks on domestic prices. The Bank notes that staff working papers describe research in progress and do not represent Bank policy. The paper models commodity exports and imports, price and wage rigidities, and financial conditions that can move with the commodity cycle. It finds that exchange-rate pegs produce materially worse outcomes for commodity exporters, whereas for commodity importers strict domestic inflation targeting can perform poorly because offsetting higher input costs would require large falls in output and wages. In emerging and developing economies, where risk premia are more closely tied to commodity prices, the trade-offs are sharper and implementing the optimal policy is harder because it requires sufficient credibility to keep inflation expectations anchored amid greater volatility in nominal variables. Across model variants, relatively stable wage growth is closest to the optimal policy.