How Should Central Banks Respond to Non-neutral Inflation Expectations?

This paper investigates the net real inflation effect on output in ten countries, comprising both advanced and developing countries. An indicator is introduced to compute the net effect of inflation on output (NIEO) based on the difference between two concepts of core inflation, where both are computed using the decomposition of VAR residuals. We find that for all countries, when inflation is increasing the NIEO is significantly positive and is negative during periods of decreasing inflation. Typically, countries which follow anti-inflationary policies if the NIEO is of small magnitude suffer relatively minimal damage in output, whereas if the same policies are undertaken when the NIEO is large the damaging effects on output could be much greater. This suggests that the NIEO could be a useful indicator of the likely effects of policy, especially countries which have frequent episodes of high inflation, and in those countries which have had quite successful inflation-targeting policy, i.e. the timing of monetary policy actions could be optimized to take account of this real effect of inflation.