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Working Paper Series

The case for a positive

euro area inflation target: evidence from France, Germany and Italy

Klaus Adam, Erwan Gautier, Sergio Santoro,

Henning Weber

Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.

No 2575 / July 2021

Price Micro Setting Analysis Network (PRISMA)

This paper contains research conducted within the Price Micro Setting Analysis Network (PRISMA). PRISMA consists of economists

from the ECB and the national central banks (NCBs) of the European System of Central Banks (ESCB).

PRISMA is coordinated by a team chaired by Luca Dedola (ECB), and consisting of Chiara Osbat (ECB), Peter Karadi (ECB) and Georg

Strasser (ECB). Fernando Alvarez (University of Chicago), Yuriy Gorodnichenko (University of California Berkeley), Raphael Schoenle

(Federal Reserve Bank of Cleveland and Brandeis University) and Michael Weber (University of Chicago) act as external consultants.

PRISMA collects and studies various kinds of price microdata, including data underlying official price indices such as the Consumer

Price Index (CPI) and the Producer Price Index (PPI), scanner data and online prices to deepen the understanding of price

setting

behaviour and inflation dynamics in the euro area and EU, with a view to gaining new insights into a key aspect of monetary policy

transmission (for further information see https://www.ecb.europa.eu/pub/economic-research/research- networks/html/researcher_prisma.en.html)

The refereeing process of this paper has been co

-ordinated by a team composed of Luca Dedola (ECB), Anton Nakov (ECB), Chiara Osbat (ECB), Elvira Prades (Banco d'Espana), Sergio Santoro (ECB), Henning Weber (Bundesbank).

This paper is released in order to make the results of PRISMA research generally available, in preliminary form, to encourage

comments

and suggestions prior to final publication. The views expressed in the paper are the author's own and do not necessarily reflect those of

the ESCB. ECB Working Paper Series No 2575 / July 20211

Abstract

Using micropricedataunderlying theHarmonized Indexof Con- sumer Pricesin France, GermanyandItaly ,weestimate re lativeprice trends overtheproduct lifecycle andshowthat minimizingprice and mark-up distortionsin thepresence ofthese trendsrequires targeting a signicantlypositiv ein ationtarget.Relativeprice trendsshift the optimal in ationtarget upfr om alevelofzerop ercent, assuggested bythe standardstic kyprice literature,toarange of1.1%- 2.1%in France,1.2%-2.0% inGerman y, 0.8%-1.0%inItaly,and1.1-1.7% in the EuroArea (threecoun trya verage).Dierencesacross countries emerge dueto systematicdiere nc esinthestrengthofrelativeprice trends. Otherconsiderations nottak enin toaccountin thepresent paperma ypushup theoptimal in ationtargetsfurther.The welfare costs associatedwithtargeting zeroi n ationturn outto besu bstan- tial andrange bet ween2.1%and4.5%ofconsumptionin present-v alue terms.

JEL Class.No.: E31,E52

Keywords:Optimal in

ationtarget, microprice trends,w elfare

ECB Working Paper Series No 2575 / July 20212

Non-TechnicalSummary

This paperestimatesthe optimalin

at ionrate that minimizesthewe l- fare consequencesof distortedrelativ eprices inFrance,German yand Italy.

Prices ofgo odsandservicescanget distortedb yin

ation whenever nom- inal pricesare `sticky', e.g.,whentheyadjust onlyinfrequ en tlyo ve rtime.

In suchasituation, in

ationcan causethe relative priceof goo dsto drift: positiveratesof in ation,for instance,cause therelativ eprice ofgo ods to fall overtimeinthe absenceprice adjustments; likewise, de ationcauses the relativepr iceofgoods toincrease overtime. In lightofthis,the present paper answers asimple question:whatdrift in relativepricesshould monetaryp olicyimplemen tin ordertomaximally align priceswith theirecien tv alues?Itshows thatpricestick iness makes it optimalto targetp ositive ratesofin ationinallthree cou ntries consid- ered. Thisis optimalb ecauseit isecient- ona verage acrossproducts- that relativeproduct pricesfallov ertime, albeit atdierentspeedsacross countries. This ndingrepresen tsasignicant departurefrom standardarguments made inthe sticky priceliterature,which -for itsv astmajority -rely on modelsthat donot allow fore cienttrendsin relative prices(onaverage across products).Asa result,s tandard models concludethattheoptimal in ation rateis zer oorverycloseto zero.The presentpaper shows that this isfar fromtrue: pricestic kinessalone causesan in ationratebet ween

1.1% and1.7% tob eoptimal intheEuroArea.

Clearly,a completeconsideration ofthe questionof theoptimal in ation target mustalsotak eother aspectsinto account thatarenotaccoun ted for withinthe pre sentpaper.Theseconsiderationscom prisethedesire to avoidhittingthe low erb oundconstraintonnominalin terestrates, thedesire to avoidde ationinindividual countries forminga heterogeneouscurrency union, anda rangeof otherf actors fromwhic hthepresentpaper abstracts.

This said,the optimalin

ation ratesestimated inthe present paper shiftan importantcornerstonedetermining theoptimal in ationtarget withinsuc h a morecomplete analysis. Considering themicro pricedata underlying theconstruction oftheHar- monized Indexof ConsumerPrices (HICP)in France, Germany andItaly the paperestimatesthe ecient ratesof relativepriceincrease/dec re ase overthepro ductlife cycleforal argeset ofpro duc ts.While theecient relativeprice trendsdier widelyacross dierent product categories,they showconsiderable persistence overtime anddisplaycommonpatterns across

countries.In particular,the relative priceof goodsfalls rather stronglyo verECB Working Paper Series No 2575 / July 20213

the productlifetimein allcoun tries,evenif this eectissomewhat lesspro- nounced inItaly .Therelative priceof services,howev er,is large lystable overthepro ductlifetime (FranceandItaly) orev enslightlyincreases ov er time (Germany).Tak entogetherthesefactsimply thatthe ecientrela- tiveprice falls,on av erageacross goodsandservices,so thata signicantly positiverateof in ationis optimalin allthree countries.

If thecen tralbanktargetsan in

ationrate ofzero insuc ha setting,as wouldb eprescribedb ystandard stickypricemo delsthatdonotallow for trends inrelativ eprices,then thisgeneratesconsiderabledistortions inrela- tiveprices andan increasein av eragemark-ups. Asa result,economicwel- fare declinesb yseveralp ercentagepoin tsinconsumption-equivalentte rms.

Targetingan in

ationrate ofzero would thus be severelysuboptimal. ECB Working Paper Series No 2575 / July 20214

1 Introduction

The factthat nominalprices failto

exiblyadjust ov ertime isoneofthekey reasons whyin ationcan giv erise tosignicantwelfarecosts. Theidea that in ation cangenerate pricemisalignmen tsand throughthesemisalignments welfarelosses goes backallthe wayto Lucas(1972) andPhelps (1970).It is enshrinedin itsmo dernform, followingW oo dford(2003),invirtuallyall structural economicmo delsentertainedb ycentralbanks. Minimizing priceand quantit ymisalignmentsiscentral inmonetary economics becauseith aspro ventob eaquantitatively importan tforce determining theoptimal in ationtarget inmonetary policy models, see Schmitt-GroheandUribe (2010)for anoverview. Whileoptimal targets are alsoaected by arangeofadditional considerations,e.g., by thepres- ence ofa low er-boundconstraintonnominalrates(Adam andBilli(2006,

2007), Coibion,Goro dnichenkoandWieland(2012),L'Huillierand Scho enle

(2020)), bythedesire too vercome down wardrigiditiesinnominalw ages (Kim andRuge-Murcia (2009)),or by thedes iretominimize cashdistor- tions (Khan,Kingand Wolman (2003)),th eseadditionalconsideration stend to movethein ationtarget onlyb yquan titatively smallamoun tsunder (Ramsey) optimalmonetary policy . 1 Standard monetarymo delsthusconclude thatthecentr albank should target anin ati onrateofzero orv eryclose tozero tominimize theeects of pricemisalignmen t.Interestingly, policymakershave -atleastimplicitly - takenthismess ageon board.TheEurop eanCen tralBank(ECB),for example, whenpro vidingitsjusticationfor anin ation objectiv eof "close to butb elowtwop ercent",liststhreereasonswh yitsobjectiveis higher than zero , therebyackno wledgingthatzeroin ationisan importan treference point

2The goalof thepresen tpap eristosho wthatthereference poin t

of zeroin ation ismisguided whenit comesto determiningthe optimal in ation targetfor theEuro Areaand thatthe referencep oint shouldb e signicantlyhigher thanzero. In recentwork, AdamandWeb er(2019) spell outageneraltheoryof price andquan titydistortionsthattakes into account thatmoderneconomies 1 This istrue withsome exceptions.Adam, Pfaeuti andReinelt (2020)sho w,for in- stance, howtheeectiv elo werbound onnominalratescan-in combinationwithlo w natural ratesof interest -justifytargetingsignican tlyp ositive ratesof in ationunder optimal monetaryp olicy.This,howev er,requires deviationsfromthestandardmodelin the formof subjectiv ehousingpriceexpectations.

2The ECBstates thefollo wingthree reasonsforpicking ap ositive in

ationob jective: (1) thelo wer-boundconstraintandassociated de ationrisks,(2)the heterogeneity in country-levelin ation ratesandthedesire toprev ent de ationin individualco untries, and (3)the poten tialoverstatementofthe truein ationrateduetounaccounted quality progress. Ourestimates fullytak ein toaccountreason (3),becauseunaccoun tedquality progress ofnew products causestherelative priceof existingpro ductstofall,whic hin turn causesp ositiverateofin ationto be optimal.Th ethree reasonslisted above are

stated at:https://www.ecb .europa.eu/mopo/strategy/pricestab/html/index.en.htmlECB Working Paper Series No 2575 / July 20215

are characterizedby ahighdegreeof product(orrm) turnov er.They show that theoptimal in ationtarget minimizingprice andquan tity distortions then ceasesto be zero.Instead,theoptimal targetis determinedb ythe ecientt rendsinrelativepriceso ver thelifetimeofpro ducts.Sp ecically, if therelativ epriceof productsoptimally de clinesover theproductlifetime, then positivein ationbecomes optimal,as weexplainfurther insection 2. 3 The previousinsigh thasthep otential toshift animportantgoalp ost relevantformonetary policy designand theaimofthe present paper isto determine itsquan titativeimportanceinthe EuroArea.Importan tly, the papers howsthattakinginto accountthepresence oftrends inrelativeprices shifts thereference in ationrate inthe EuroArea upto alev elb etw een1.1% and 1.7%.This represents aquantitatively sizableshift. 4 Our analysisfo cusesonthethree largestEuro Areaeconomies (France, Germanyand Italy),whic hjoin tlyaccoun tfor64%of EuroAreaGDPin

2019. Specically,weestimate theecientrelativ eprice trendsin these

economies fora largen umb erofproductcategoriesandusethese estimates to provideatheory-consisten testimate oftheaggregatein ationrate that minimizes thew elfareeectsofrelativ eprice distortions.The microprice data usedinour analysishas recently become av ailableunderthe Eurosys- tem's PRISMA(Price-setting Microdata Analysis)researchnet work. Itis used forthe constructionof the EuroArea's HarmonizedIndexof Consumer Prices (HICP)and contains morethan80million priceobserv ations.The data coversbetw een65%and84%oftheHICPexp enditure basket inthe considered countries,which comparesfavorably toprior comparativeanal- yses ofmicro pricedata inthe EuroArea, e.g.,the onesc onducted shortly after inceptionof theEur oArea undertheEurosystem'sIn ation Persis- tence Network.Dhyneetal. (2006),forinstance,considered alar ger set of Euro Areacoun tries,butonly50 rathernarro wlydened produ ct s. Our estimatesfor thep eriod 2015-2019showthattheoptimal in ation rate minimizingthe welfare costsassociatedwith re lativeprice distortions ranges between1.1%and2.1%in France, bet we en1.2% and2.0%inGer- manyand bet ween0.8%and1.0%inItaly.

5The optimalin

ation ratesare signicantlyab ovezerobutalsodisplay quitesome heterogeneity . Giventhe highdegree ofdata cov eragefor theE uroArea,wealsopro- vide anestimate ofthe optimalEuro Areai n ationtarget usingthe evidence3 In asetting withoutpro ductturno ver, relativepricetrends arenaturally zero:pro d- ucts can(on av erageacrossproducts)neitherappreciate nordepreciate inpriceagainst the averageproduct.Simple modelswithoutpro ductturno verthus concludethat the optimal in ationtargetis zero.

4This doesnotimply thatthe in

ationtarget inthe EuroArea, which takes into accountalso otherconsiderations, ismo ved by thesameamount.Thedesire toavoid de ation inindividual countries, forinstance,becomes aless strongconce rnforEuro

Area monetarypolicy ,ifthereferencein

ation rateisalreadyhigher thanzero.

5The estimatefor Italyis forthe perio d2016-2019, forreasons discussedinthemain

text.ECB Working Paper Series No 2575 / July 20216 obtained fromthe threelarges tEuro Areaeconomies, withalternativ ees- timation approachesdelivering arangebet ween 1.1%and 1.7%.Clearly, taking intoaccount additionalconsiderationsrelev antford etermin ingthe optimal in ationtarget, e.g.,the existenceof alo wer-b oundconstrain tfor nominal rates,will likely raisetheoptimalin ation targetfurth er .Whil ea full quantitativeanalysistakingin toaccoun tsuc hadditionalconsiderations is beyondthescope ofthe presentpap er,it isan interestingsubject for future research. If wefocus onasubs ample comparableacross countries,optimalin ation targets thatminimizeprice andmark-up distortionsdier acrossF rance, Germanyand Italy, becauseofimp ortantdierencesin therelativ eprices trends presentatth edisaggregate level.Inparti cu lar,wesho wthat positive rates ofin ation aremainly dueto theb ehavior ofgo ods prices,whileservice prices, butalso foo dprices,contributevery littleor makeeven negative contributions. Relativeprice trendsin goo dsp ricesareaboutt wiceasstrongin Fran ce and GermanycomparedtoItaly,whic his toa largeextentdue toahigher trend ratein theexp enditurecategory "clothingandfoot wear". Asa result, the optimalin ationrate inthe formert wo countries isconsid erablyhigher than inItal y. Relativeprice trendsdi sp layaconsiderableamountofpositive corre - lation acrossF ranceandGermany atthe disaggregate dlev el(COICOP3), but Italylo oksdierent.

6Relativeprice trendsin Italyare ov erallw eaker

and covaryonlylittle withtheonesin Germany atthe COICOP3lev el.W e showthat thisis partlydue tothe factthat therates ofsame-go od price in ation inItaly areuncorrelated withthe onesin Germany .The in ation rates, whichincludein ation contributions fromold andnew goods,covary neverthelessconsiderably bet weenGermanyandItalyatthe disaggregate level. 7

Wealso inv estigatehowtheoptimalin

ation rateshave chan ged ov er time, byanalyzing howecient relativepricetrends changedov ertime. Comparing thebaseline perio d(2015/6-2019)toequallylongp eriods pre- ceding thebaseline perio d,wendthatoptimal in ationwas eit herv ery stable overtimeormigh tha ve declinedsomewhat.Aremark ablefeatureof the datais thatthere existsa strongp ositive correlationo ver timeforthe optimal in ationratesa disaggregateexp enditure level (COICOP3)ineach of thethreecoun tries.This suggeststhatrelative price trendstend tob e rather stableo vertime.Thisinturn would implythat ourestimates forthe optimal in ationrate inthe baselinep eriod (2015/6-2019)are alsorelevant for whatis optimalin the notto odistantfuture, i.e.,once theeectsof the6 COICOP (Classicationof IndividualConsumption by Purpose) isa product classi- ation systemused by statisticalagenciesinthe EuroArea.

7Yet,the level ofin

ationisgenerally low erin Italy .ECB Working Paper Series No 2575 / July 20217

Covidcri siswillhavedissipated.

Finally,w equantify thewelfarecostsassociated withsub optimalrates of in ation.T othisendw ederiv ea newanalyticresultthat allowsus to compute(to second-ord eraccuracy)theconsumption-equivalentw elfare costs ofsub optimalin ationratesin asetting withh eterogeneous ecient price trends.Wethe ncomputethepresen tvalueofconsumption-equivalen t welfarecosts inthe EuroArea fort wo alternative scenarios.In therstsce- nario, weassumethat in ationsta ysp ermanently atitslow averagelev els displayedov ertheperiod2015/6-2019 inthe consideredcountries.Aggre- gate welfarelossesrelated toprice distortionsare ov erallsmall anddo not exceed 0.5%of consumptionin present-v alueterms. Inthesecondscenario, wecoun terfactuallyassumethatthe central banktargets ani n ationrate of zerop ercent,aswouldb eoptimal intheabsenceof relativepricetrends. Aggregate welfarelossesare thensubstan tialand rangeb etween2.1% and

4.5% ofconsumption inpresen t-value terms.Thisshowshow welfare costs

quicklyrise witht hedeviation fromtheoptimaltarget andho wthe norm a- tiveprescriptions comingout ofstandard sticky pric emo dels(zeroin ation) giverise tosev erelysub optimaloutcomes.

The nextsection explainswh yp ositivein

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