How important is the financial sector to price indices in an inflation targeting regime? Empirical analysis of the UK and the US

This paper investigates whether incorporating stock prices into the price index that will be targeted by the central bank can be more beneficial in terms of economic stability. It also looks into the question of whether central banks should use stock prices as a component in the output stability index. Optimization technique is used to estimate optimal weights for different sectoral prices. The weights, which depend on sectoral parameters, are different from those used in computing the consumer price index. Using data for the UK and the US, the results suggest that using the constructed broader measure for inflation achieved higher output stability than using the consumer price index. The results, therefore, highlight importance of having a broader measure of inflation in improving macroeconomic stability in an inflation targeting monetary policy environment.