The Bank of England has published a staff working paper finding that expenditure weighted Consumer Price Index inflation may not be the most effective guide for interest rate policy when the sectors driving prices differ from those transmitting monetary policy. New euro area data show that discretionary sectors account for about 95% of consumption contractions and 96% of employment contractions during recent recessions, while necessity sectors account for about 86% of inflation fluctuations. Contractionary monetary policy shocks also reduce discretionary consumption and employment most, even though necessity prices respond more strongly. A two sector New Keynesian model attributes this mismatch to the greater interest and income sensitivity of discretionary demand and the concentration of hand to mouth workers in discretionary industries. Simple rules placing nearly all weight on discretionary inflation improve welfare by avoiding contractions in policy sensitive sectors in response to price movements in sectors where interest rates have limited effects on quantities. With empirically observed price stickiness, a discretionary inflation rule closes about two thirds of the welfare gap between a CPI inflation rule and Ramsey policy. Under the estimated distribution of euro area shocks, it reduces welfare losses by 9.4%, mainly through lower sectoral inflation volatility rather than lower aggregate real volatility. The paper does not propose replacing headline inflation as a purchasing power measure and does not represent Bank of England policy.
2026-09-25Bank of England
Bank of England staff paper finds discretionary inflation may better guide euro area monetary stabilization
A Bank of England staff paper finds that euro area CPI weights may differ from the weights best suited to monetary stabilization because inflation is concentrated in necessity sectors while policy primarily affects discretionary activity and employment. A discretionary inflation rule closes about two thirds of the modeled welfare gap between a CPI rule and Ramsey policy and reduces welfare losses by 9.4% under the estimated distribution of euro area shocks.