Working Paper: NBER ID: w24319
Authors: Shangjin Wei; Yinxi Xie
Abstract: Two strands of the literature suggest that PPI inflation, rather than CPI inflation, should be the targeting variable in a monetary policy rule. The distinction between these two rules would only be important if the two inflation indices do not co-move strongly. The first contribution of this paper is to document that the two inflation gauges did co-move strongly in the last century but the correlation has fallen substantially since the start of this century. The second contribution is to propose a structural explanation for this divergence based on a lengthening of world production chains since 2000. This theory implies that the decline in the correlation is likely to be permanent and a rethinking of the monetary policy rules has become more important. Our multi-stage multi-country production model has additional predictions on the behavior of CPI and PPI inflation beyond a fallen correlation, and these predictions are also confirmed in the data.
Keywords: CPI; PPI; Inflation; Monetary Policy; Global Production Chains
JEL Codes: E5; F1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lengthening of global production chains (F69) | decline in correlation between CPI and PPI (E31) |
| increase in number of production stages (L23) | greater wedge between CPI and PPI baskets (C43) |
| increase in number of production stages (L23) | reduced correlation between CPI and PPI (E31) |
| increase in number of production stages (L23) | decrease in responsiveness of CPI to productivity shocks (E31) |
| increase in number of production stages (L23) | decrease in responsiveness of PPI to productivity shocks (O49) |
| decrease in responsiveness of CPI to productivity shocks (E31) | necessity to reevaluate monetary policy rules (E61) |
| decrease in responsiveness of PPI to productivity shocks (O49) | necessity to reevaluate monetary policy rules (E61) |
| decline in correlation between CPI and PPI (E31) | optimal monetary policy should incorporate PPI targeting (E31) |