Inflation targeting - Domestic inflation versus CPI inflation

Abstract

How should monetary policy deal with the so-called ‘direct’ exchange rate pass-through, given that the impact on CPI inflation typically occurs relatively quickly, but the impact of a monetary policy response occurs much more slowly? For example, were the exchange rate to depreciate suddenly today, CPI inflation may rise in the very near-term. If, in response, interest rates were raised, the impact of tighter monetary policy would not be felt until some time after the initial inflationary impulse, by which time that impulse may have dissipated, making the initial monetary policy response unnecessary or undesirable. One suggested approach is for monetary policy to target a measure of ‘domestic’ inflation that excludes the direct exchange rate effects on inflation. This paper provides an overview of the economic research on the topic of targeting CPI inflation versus domestic inflation.