Academic journal article Seoul Journal of Economics

Inflation Targeting, Aggregation, and Inflation Persistence: Evidence from Korean CPI Components

Academic journal article Seoul Journal of Economics

Inflation Targeting, Aggregation, and Inflation Persistence: Evidence from Korean CPI Components

Article excerpt

This paper studies the impact of inflation targeting on the evolution of inflation persistence and the effects of aggregation across expenditure categories. For this purpose we use disaggregate quarterly data on 12 major subcategories of the Korean CPI. We compare persistence in a sample covering 1986Q1-1997Q2 with persistence under inflation targeting between 1999Q1 and 2010Q2. The main results are three-fold. First, the persistence of headline inflation as well as most CPI categories falls after the adoption of inflation targeting. Second, the evidence points to a large cross-sectional heterogeneity in the degree of inflation persistence. Third, while aggregation of heterogeneous categories induces additional persistence in the early part of the sample, a "reverse aggregation effect" is found in the second half: the persistence of the aggregate CPI inflation rate is significantly smaller than the average of persistence estimates across sectors. This is consistent with the Bank of Korea effectively stabilizing aggregate shocks under inflation targeting. Our paper provides the first evidence of disaggregate inflation persistence for an Asian emerging market economy.

Keywords: Inflation persistence. Sectoral inflation, Aggregation, Inflation targeting. Monetary policy strategy. Dynamic factor model

JEL Classification: C22, E5, E31

I. Introduction

The degree of inflation persistence contains valuable information about the effectiveness of monetary policy. Well-anchored inflation expectations as well as a clear and credible policy mandate to achieve price stability are generally thought of as reducing inflation persistence. Therefore, the evolution of inflation persistence in the aftermath of the adoption of a new monetary policy regime is particularly informative.

Besides the persistence of the aggregate inflation rate, the persistence properties of inflation at a disaggregate level are also a valuable input for monetary policy. The rationale for using disaggregate data is that the aggregation process itself - using heterogeneous individual components - could lead to spuriously high persistence estimates for the aggregate inflation series. Therefore, the assessment of the true degree of inflation persistence using aggregate Consumer Price (CPI) inflation data is obscured by an aggregation bias. The persistence of aggregate inflation is typically found to be substantially higher than the average persistence of the CPI components.

While inflation persistence at the level of the aggregate CPI received considerable attention over the recent years, surprisingly few studies analyze inflation persistence at a disaggregate level. The lack of empirical research in this field is mostly due to data limitations. In fact, most empirical studies focus on either the U.S. economy or selected European economies for which detailed disaggregate data, even for very high levels of disaggregation, is available. For emerging market economies, where data limitations are more severe, even less is known about persistence at a sector level. This is unfortunate since it is in emerging market economies where the cross-sectional heterogeneity in inflation persistence is likely to be particularly large.

This paper studies the evolution of inflation persistence across sectors after the adoption of a new monetary regime and the effects of aggregation for the case of Korea. The adoption of inflation targeting (G?) by the Bank of Korea in 1999 is likely to affect the persistence of inflation both at the aggregate and the disaggregated level and, by doing so, also the quantitative properties of the aggregation bias.1

We use data on 12 major subcategories of the Korean CPI to establish three key findings: First, persistence of the aggregate as well as most CPI categories falls after the adoption of IT. Second, the evidence points to a large degree of cross-sectional heterogeneity in the degree of inflation persistence. …

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