Sectoral Shocks and Monetary Policy in the United Kingdom*
Published date | 01 August 2023 |
Author | Huw Dixon,Jeremy Franklin,Stephen Millard |
Date | 01 August 2023 |
DOI | http://doi.org/10.1111/obes.12541 |
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 85, 4 (2023) 0305-9049
doi: 10.1111/obes.12541
Sectoral Shocks and Monetary Policy in the United
Kingdom*
HUW DIXON,† JEREMY FRANKLIN‡ and STEPHEN MILLARD§
†Department of Economics, Cardiff Business School, Aberconway Building, Colum Drive Cardiff,
CF10 3EU, UK
(e-mail: dixonh@cardiff.ac.uk)
‡Bank of England, Threadneedle Street London, EC2R 8AH, UK
(e-mail: jeremy.franklin@bankofengland.co.uk)
§National Institute of Economic and Social Research, 2 Dean Trench Street London,
SW1P 3HE, UK (e-mail: s.millard@niesr.ac.uk)
Abstract
We examine the extent to which monetary policy should respond to movements in sectoral
inflation rates using a Generalized Taylor model that takes specific account of the sectoral
make-up of the consumer price index. We calibrate the model for each sector using the
UK consumer price microdata. We find that a policy rule allowing for different responses
to inflation in different sectors outperforms a rule targeting only aggregate inflation, as
does a rule responding only to core inflation. However, we find that the optimal sectoral
rule only leads to a small absolute improvement in terms of extra consumption.
I. Introduction
A key question for monetary policymakers is how to deal with ‘relative price’ shocks:
that is, movements in individual prices that do not reflect aggregate inflationary pressure
but that can, as a result of nominal rigidities, lead to temporary changes in inflation.
As an example, in November 2017, inflation rose above 3% driven by increases in oil
prices, combined with rises in the price of food and other imports resulting from the
depreciation of sterling following the vote to leave the European Union. The question as
to how monetary policy should respond to these relative price shocks was discussed in
Carney (2018) and the more general question of how monetary policy should respond to
JEL Classification numbers: E17, E31, E52.
*The views expressed in this paper are those of the authors and should not be taken as representative of the
views of the Bank of England or any of its policy committees. The authors are extremely grateful to Conor
Sacks and Kun Tian for research assistance, and to Haroon Mumtaz for his help and advice on the empirical
section and for sharing the Matlab code from his previous work, and to Francesco Zanetti and three anonymous
referees for their insightful comments. The authors also wish to thank seminar participants at the Universities of
Cardiff, Durham, Manchester and Singapore and participants at the Association of Southern European Economic
Theorists Conference in Limassol, November 2012, the Royal Economic Society Annual Conference in London,
April 2013 and the Anglo-French Macroeconomics workshop at Marseilles, December 2014 and the ICMAIF
Crete 2015 for useful comments. Any errors and omissions, of course, remain the fault of the authors.
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©2023 Bank of England. Oxford Bulletin of Economics and Statistics ©2023 Oxford University and John Wiley & Sons Ltd.
806 Bulletin
supply shocks (including relative price shocks) in Carney (2017). In both cases, he argued
that it was appropriate to adopt a policy that was more expansive than would be implied by
a conventional Taylor rule, where the central bank would react to high inflation whatever
the cause.
This paper develops a framework to integrate sectoral shocks – which lead to relative
price movements – into a model of the UK economy to examine more closely the
implications of these shocks for inflation and the conduct of monetary policy. More
specifically, we seek to link together sectoral shocks in the consumer price index (CPI)
data to the behaviour of the economy at the aggregate level. This will enable us to
address several questions about the causal links between the aggregate and sectoral
levels, though in this paper we concentrate on the practical policy issue of how monetary
policy should respond to sectoral shocks. There are several papers that model sectoral
shocks in the United States including Mackowiak, Moench, and Wiederholt (2009)and
Boivin, Giannoni, and Mihov (2009), in the United Kingdom, including Ellis, Mumtaz,
and Zabczyk (2009), and, more recently, in Japan (Okuda, Tsuruga, and Zanetti (2021)).
Boivin et al. (2009) find using US data that most of the fluctuations in monthly sectoral
inflation rates are due to sector-specific factors. Ellis et al. (2009) arrive at a similar result
using quarterly data. In addition, they find that while sectoral inflation fluctuations are
persistent in the raw data, this persistence is due to common macro components and not
to the sector specific disturbances. The sector-specific shocks themselves are much less
persistent. Therefore, the overall picture is one in which many sectoral prices fluctuate
considerably in response to sector specific shocks, but respond sluggishly to aggregate
macro shocks, such as monetary policy. As argued by Mackowiak et al. (2009), this could
be because firms focus mainly on what is going on in their sector and pay rationally little
attention to the macro factors.
The key innovation of this paper is to link the 12 CPI Classification Of Individual
Consumption by Purpose (COICOP) sectors directly into a New Keynesian Dynamic
Stochastic General Equilibrium (DSGE) model of the UK economy. We achieve this
by using the UK CPI microdata for the period 1996– 2006 to calibrate a Generalized
Taylor (GT) Economy for each of the 12 COICOP sectors (excluding food, petrol and
energy which are assumed to be flexibly priced). To do this we estimate the cross-sectional
distribution of durations within each CPI sector as in Dixon and Le Bihan (2012).1The GT
is then based on the estimated cross-sectional distribution of durations, the cross-section
relating to the proportions of firms setting prices for each duration. This is done at the
level of the 12 sticky-price COICOP sectors making up the CPI.
Thus, for each CPI sector we have the proportion of prices in that sector that have
a duration of one quarter, two quarters and so on up to 12 quarters. We thus have 12
proportions for each of the 12 COICOP sectors, a total of 144 estimated parameters,
which reflect the actual distribution of price-spells within each COICOP sector in the
UK. Following Taylor (1999,2016), we adopt the Taylor staggered contracts model
within each of the 144 sectors (each of the 12 durations within the 12 COICOP sectors).
This is a ‘generalized’ Taylor model in that the original Taylor model assumes a single
economy-wide duration across the whole economy. The advantage of the GT model is that
1For econometric issues in the estimation of CSD see Dixon and Tian (2022).
©2023 Bank of England. Oxford Bulletin of Economics and Statistics ©2023 Oxford University and John Wiley & Sons Ltd.
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