Should Central Banks Target Consumer or Producer Prices?

Should central banks target consumer price inflation (CPI) in the setting of monetary policy, as has been orthodoxy in most of the developed world since the 1990s? Several prominent recent studies have argued against this, based on the finding that targeting CPI can make expectations of higher consumer prices self-fulfilling. If the central bank responds to an extrinsic-shock-driven rise in CPI expectations by driving up the real interest rate, the argument goes, the resulting improvement in the terms of trade can increase consumer prices even if producer prices fall. These studies are, however, based on a flawed assumption that what motivates current transactions is the money consumers have after leaving the goods market. Using what is shown to be the more defensible assumption that such transactions are motivated by the money consumers have before entering the goods market, this paper demonstrates that targeting CPI helps to prevent self-fulfilling expectations. This is because an improvement in the terms of trade now serves to exert downward pressure on CPI, irrespective of the response of producer prices. Consequently, the initial rise in CPI expectations is not self-fulfilling under CPI targeting, whereas under producer price inflation (PPI) targeting, improvements in the terms of trade act as an undesirable negative cost shock. Central banks in open economies would therefore be ill-advised to shift from CPI to PPI targeting, as the latter is more likely to result in welfare-reducing, self-fulfilling expectations.