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On the Wedge Between the PPI and CPI Inflation Indicators

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If the producer price index (PPI) and consumer price index (CPI) diverge, optimal monetary policy—as suggested by the literature—needs to incorporate PPI inflation as a targeting variable. Using PPI as a forecasting variable for CPI becomes insufficient.

We document that a structural change has occurred in the correlation between the two inflation measures. Throughout the late 20th century, the correlation between the two inflation indexes was high. As a result, the choice of inflation index used in the conduct of monetary policy was not important, in practice. However, since the early 2000s, the two inflation indexes have diverged. This can exacerbate any shortcomings of a monetary policy tool that targets only the CPI index.

The importance for central banks to revise their policy rules depends on whether the divergence of the two indexes is structural (permanent) or transitory. This paper proposes a structural explanation for the divergence, based on the growth of global supply chains, and suggests that this divergence might be a persistent phenomenon. The key idea is that, as vertical specialization continues (i.e., with an increase in the average number of production stages in the world economy), more intermediate goods enter the national PPI basket. As a result, the common component in the two price indexes—domestically consumed final goods that are also domestically produced—has a smaller share in the PPI basket.