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Same Target, Different Economies: A Cross-Country Analysis of Inflation

KEY TAKEAWAYS

  • Many central banks have adopted inflation targeting in recent years. But does a common inflation target across diverse economies make sense?
  • Many advanced economies have embraced a 2% target. Yet a cross-country analysis of inflation shows these nations have different patterns of rising consumer prices.
  • Evidence of varied inflationary forces raises a question of whether a 2% inflation target is best practice across advanced economies.
Woman looking at price tag on a dress

By

YiLi Chien , Julie Bennett
Thursday, March 5, 2020

Over the past three decades, many central banks around the world have adopted inflation targeting—a policy that sets a target (or range) for the country’s inflation rate as measured by a specific price index.See Hammond. Many advanced economies, including the United States, the European Union, the United Kingdom and Japan, have set their inflation target at or close to 2%.

Central banks have set their inflation targets low so as to mitigate the costliness of rapidly rising prices, but not too low so as to teeter on the edge of deflation—an economic state that could be even more costly.See Billi and Kahn. Using a New Keynesian framework, Coibion, Gorodnichenko and Wieland found little evidence to support the current 2% inflation targets, and their results suggest that the optimal inflation rate may be less than 2%. Throughout most of the past decade, however, inflation rates for several advanced economies have fallen short of their 2% target, sparking a renewed interest in reviewing the optimal level of inflation targets. In practice, the specific 2% inflation target may not be universally optimal. The driving forces behind inflation rates could be quite different across countries; therefore, the implementation of the same monetary policy tools—such as forward guidance or quantitative easing—could have varied effects on inflation rates.

In this article, we examine the inflation contributions of different consumer expenditure categories across several major advanced economies using national consumer price index (CPI) data from the Organization for Economic Cooperation and Development (OECD). The overall CPI reported by the OECD comprises 12 expenditure categories,These 12 categories are labeled as follows: food and nonalcoholic beverages; alcoholic beverages, tobacco and narcotics; clothing and footwear; housing, water, electricity, gas and other fuels; furnishings, household equipment and routine household maintenance; health; transport; communication; recreation and culture; education; restaurants and hotels; and miscellaneous goods and services. and the inflation contribution of each category is calculated by the OECD using the category’s inflation rate and consumption weight.More detail on the OECD calculation of inflation contribution can be found here. The inflation contributions across all 12 categories sum to the overall CPI inflation rate. Therefore, we can identify the relative importance of each expenditure category to the overall CPI inflation rate for each country and compare inflation compositions internationally.

Identifying Inflation Components

We use OECD-reported national CPI data for five countries: the U.S., Japan, France, Germany and the U.K. The OECD constructs each country’s CPI following the Classification of Individual Consumption According to Purpose (COICOP) as published by the United Nations Statistics Division, and this standardized methodology allows for cross-country comparisons of the data.Note that the OECD-reported CPIs are not the official price indexes by which each country gauges its inflation target, but the inflation rates reflected by the OECD CPIs closely resemble those reflected by the country-reported CPIs. We use the annual inflation rate and inflation contribution data series at a monthly frequency over the time period of January 2012 to September 2019.These data reported by the OECD are not seasonally adjusted, and the CPIs have a base year of 2015. The relatively short span of data is due to the limitation of data availability.

The accompanying table reports the average overall CPI inflation rate and the top five inflation contribution components for each country over the time period. For each country, the average overall CPI inflation rate falls below the 2% level by varying degrees, ranging from 1.8% in the U.K. to 0.69% in Japan. For all countries except Japan, “housing, water, electricity, gas and other fuels” expenditures contributed the most to overall inflation. (Japan’s highest contributor is “food and nonalcoholic beverages” expenditures.)

Top Five Contributors to Inflation
Country Average Overall Inflation Rate Expenditure Category Inflation Contribution (Percentage Points) Share of Overall Inflation Rate
U.S. 1.56% Housing, Water, Electricity, Gas and Other Fuels 1.00 64%
Miscellaneous Goods and Services 0.21 13%
Health 0.17 11%
Restaurants and Hotels 0.16 10%
Education 0.09 6%
Japan 0.69% Food and Nonalcoholic Beverages 0.30 44%
Housing, Water, Electricity, Gas and Other Fuels 0.09 13%
Miscellaneous Goods and Services 0.08 12%
Restaurants and Hotels 0.08 12%
Recreation and Culture 0.05 8%
France 0.94% Housing, Water, Electricity, Gas and Other Fuels 0.24 26%
Transport 0.18 19%
Miscellaneous Goods and Services 0.17 18%
Food and Nonalcoholic Beverages 0.17 18%
Restaurants and Hotels 0.15 16%
Germany 1.27% Housing, Water, Electricity, Gas and Other Fuels 0.37 29%
Food and Nonalcoholic Beverages 0.21 17%
Recreation and Culture 0.17 14%
Transport 0.13 10%
Alcoholic Beverages, Tobacco and Narcotics 0.10 8%
U.K. 1.80% Housing, Water, Electricity, Gas and Other Fuels 0.59 33%
Restaurants and Hotels 0.25 14%
Transport 0.20 11%
Alcoholic Beverages, Tobacco and Narcotics 0.14 8%
Recreation and Culture 0.13 7%
SOURCES: Organization for Economic Cooperation and Development, Haver Analytics and authors’ calculations.
NOTES: Share of the overall inflation rate is calculated by dividing the inflation contribution by the average overall inflation rate. Miscellaneous goods and services include expenditures such as insurance, financial services and personal care. The calculations are based on data from January 2012 to September 2019.

However, this broad housing category’s share of overall inflation varies quite a bit. In the U.S., housing expenditures contribute 1 percentage point to the average overall inflation rate, which means that it accounts for 64% of the total 1.56% inflation rate. Meanwhile, in France, Germany and the U.K., the housing component constitutes 26%, 29% and 33%, respectively, of each country’s overall inflation rate, and in Japan it constitutes just 13%.

As the inflation contribution of each component is calculated using both its inflation rate and its consumption weight, a component’s high inflation contribution could result from its high consumption weight or its high inflation rate. The very high importance of the housing expenditures category in the U.S. appears to result from both factors. The U.S. housing inflation rate (2.7%) as well as consumption weight (36.7%) are both the highest among the five sample countries. The housing consumption weight is especially high in contrast with those of Japan (19%) and France (9.8%).

For the U.S., Japan and Germany, the OECD reports further disaggregated CPI and inflation contribution data for the housing, water, electricity, gas and other fuels expenditure category. Therefore, we can identify which subcomponentThese subcomponents are labeled as follows: actual and imputed housing rentals; dwelling maintenance and repairs; water supply and related services; and electricity, gas and other fuels. drives this category’s high inflation contribution for those countries.The OECD does not report comprehensive disaggregated subcomponents for France (its actual and imputed housing rentals category covers only actual housing rentals) and no further disaggregated subcomponents for the U.K.; therefore, we omit the two countries from this comparison.

In the U.S. and Germany, actual and imputed housing rentals Imputed housing rentals capture the value of the housing services consumed by individuals who own their living space. These housing services are assumed to be equal to the value of the property if it were on the rental market. For more information, see the U.N. methodology. make up the majority of the category’s overall inflation contribution, accounting for 0.93 percentage points (59%) and 0.28 percentage points (22%) of each country’s overall inflation rate, respectively.For the U.S. and Japan, actual and imputed housing rentals are reported separately, but for Germany they are reported in aggregate; therefore, we compare the aggregate category across countries. In Japan, however, this subcomponent actually contributes a negative amount (–0.05 percentage points) to overall inflation,. Instead, the electricity, gas and other fuels subcomponent drives the housing expenditures inflation contribution in Japan, accounting for 0.12 percentage points (17%) of the overall inflation rate. This relatively high inflation contribution may be due in part to Japan’s shift away from nuclear energy toward coal and natural gas.

Differences in Inflation Contribution

Though the housing expenditures category ranks highly across all countries in its inflation contribution, the importance of most other expenditure categories varies quite a bit. For example, health expenditures contribute third most to inflation in the U.S., but for the other countries, it falls among the bottom four contributors. This difference might arise because of the fact that the U.S. has a more privatized health care system than the other four countries and therefore less government regulation on increasing health care costs.

Turning to transport expenditures, this category contributes a positive amount to inflation in all countries except the U.S. In the European countries, this contribution accounts for a relatively high share of the overall inflation rate, ranking No. 2, No. 3 and No. 4 in overall inflation contribution for France, the U.K. and Germany, respectively. In the U.S., however, transport actually contributes a negative amount (–0.14 percentage points) to inflation. That is, prices for goods and services related to transport in the U.S. have actually fallen over the sample period, resulting in deflationary pressure.

For all sample countries except the U.K., the OECD reports further disaggregated CPI and inflation contribution data for one subcomponent of the transport category: fuels and lubricants for personal transport equipment, which includes motor vehicle gasoline. In the U.S., the average inflation contribution of this subcomponent over the sample period is –0.18 percentage points, indicating that this subcomponent accounts for a substantial portion (128%) of the overall negative inflation contribution from the transport category.As the overall inflation contribution of the transport category is –0.14 percentage points, it can be inferred that most, if not all, of the other unreported transport subcomponents contribute a positive amount to inflation to offset the –0.18 percentage points contribution of fuels and lubricants for personal transport equipment.

Meanwhile, in the other countries, this fuel subcomponent contributes relatively little to the overall inflation contribution of the transport category, accounting for 7.5% of the transport inflation in Japan, 17% of transport inflation in France, and –23% of transport inflation in Germany. We likely see this discrepancy because gasoline prices in the U.S. have dropped more in recent years than they have in other countries, and as the U.S. is a more car-dependent country, the lower gas prices have had more bearing on overall inflation.

Our findings suggest that there is a nontrivial degree of country-level heterogeneity in the driving factors of inflation. These cross-country differences may be due to a variety of factors, such as shifting production technologies or government regulation. In light of these varied inflationary forces, the question arises whether a standard 2% inflation target is best practice across advanced economies, and future work should consider how various aspects of monetary policy affect different components of inflation.

Endnotes

  1. See Hammond.
  2. See Billi and Kahn. Using a New Keynesian framework, Coibion, Gorodnichenko and Wieland found little evidence to support the current 2% inflation targets, and their results suggest that the optimal inflation rate may be less than 2%.
  3. These 12 categories are labeled as follows: food and nonalcoholic beverages; alcoholic beverages, tobacco and narcotics; clothing and footwear; housing, water, electricity, gas and other fuels; furnishings, household equipment and routine household maintenance; health; transport; communication; recreation and culture; education; restaurants and hotels; and miscellaneous goods and services.
  4. More detail on the OECD calculation of inflation contribution can be found here.
  5. Note that the OECD-reported CPIs are not the official price indexes by which each country gauges its inflation target, but the inflation rates reflected by the OECD CPIs closely resemble those reflected by the country-reported CPIs.
  6. These data reported by the OECD are not seasonally adjusted, and the CPIs have a base year of 2015.
  7. These subcomponents are labeled as follows: actual and imputed housing rentals; dwelling maintenance and repairs; water supply and related services; and electricity, gas and other fuels.
  8. The OECD does not report comprehensive disaggregated subcomponents for France (its actual and imputed housing rentals category covers only actual housing rentals) and no further disaggregated subcomponents for the U.K.; therefore, we omit the two countries from this comparison.
  9. Imputed housing rentals capture the value of the housing services consumed by individuals who own their living space. These housing services are assumed to be equal to the value of the property if it were on the rental market. For more information, see the U.N. methodology.
  10. For the U.S. and Japan, actual and imputed housing rentals are reported separately, but for Germany they are reported in aggregate; therefore, we compare the aggregate category across countries.
  11. As the overall inflation contribution of the transport category is –0.14 percentage points, it can be inferred that most, if not all, of the other unreported transport subcomponents contribute a positive amount to inflation to offset the –0.18 percentage points contribution of fuels and lubricants for personal transport equipment.

References

Billi, Roberto M.; and Kahn, George A. “What Is the Optimal Inflation Rate?” Federal Reserve Bank of Kansas City Economic Review, Second Quarter 2008, pp. 5-28.

Coibion, Olivier; Gorodnichenko, Yuriy; and Wieland, Johannes. “The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise Their Inflation Targets in Light of the Zero Lower Bound?” The Review of Economic Studies, October 2012, Vol. 79, No. 4, pp. 1371–1406.

Hammond, Gill. State of the Art of Inflation Targeting, 4th Ed. Centre for Central Banking Studies, Bank of England, 2012.

Organization for Economic Cooperation and Development. “Consumer Price Indices (CPIs)—Complete Database,” OECD.Stat. Accessed on Dec. 16, 2019.

ABOUT THE AUTHORS
YiLi Chien 

YiLi Chien is an economist and research officer at the Federal Reserve Bank of St. Louis. His areas of research include macroeconomics, household finance and asset pricing. He joined the St. Louis Fed in 2012. Read more about the author and his research.

Julie Bennett 

Julie Bennett is a research associate at the Federal Reserve Bank of St. Louis.