Skip to main content

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


This paper investigates whether there are benefits in terms of higher economic stability from incorporating stock prices into the price index targeted by the central banks. It also looks into the question of whether central banks should use stock prices as a component of the output stability index and how the index can be constructed. An optimization technique is employed to estimate weights for the various sectoral prices. The obtained weights, which depend on sectoral parameters, differ from those used in the construction of the consumer price index, CPI. Using data from the UK and the US, our analysis demonstrates that in comparison to the CPI, our measure of inflation leads to a higher output stability. Thus, in an inflation-targeting monetary policy environment, it is important to adopt a broader inflation benchmark than the CPI for the general macroeconomic stability.

This is a preview of subscription content, access via your institution.

Fig. 1
Fig. 2


  1. 1.

    In Svensson (2002) for example, the central bank minimizes a quadratic loss function in inflation and output gap.

  2. 2.

    This view is supported by a number of authors such as Alchian and Klein (1973), Goodhart and Hofmann (2000), Goodhart (2001), Matalík et al. (2005) and Schwartz (2003).

  3. 3.

    An asset price bubble is that part of asset price movement that remains unexplained.

  4. 4.

    See Romer (2012) for details.

  5. 5.

    See Mankiw and Reis (2003) for the full discussion of the theoretical details.

  6. 6.

    Theoretical justification for the existence of sluggish and flexible prices within a system stems from the New Keynesian literature.

  7. 7.

    This assumption is used to obtain a straightforward theoretical solution. However, the empirical analysis uses a more relaxed assumption, and therefore estimates the target weights for sector prices with both correlated and uncorrelated shocks.

  8. 8.

    The deviation from the sector prices represents the unexpected shocks as a function of the sector parameters and idiosyncratic shocks.

  9. 9.

    This condition is to simplify the presentation of otherwise a long mathematical equation. However, in the empirical work, the paper uses both correlated and uncorrelated terms, which have been reported in Tables 2, 3 and 4 as well as in the “Appendix”.

  10. 10.

    See Mankiw and Reis (2003) for the full discussion.

  11. 11.

  12. 12.

  13. 13.

    The UK Share Price used is the FTSE All-Share Index, which is a market capitalization weighted index representing the performance of all eligible companies listed on the London Stock Exchange's main market.

  14. 14.

    See Bernanke and Gertler (1999, 2001) for details.

  15. 15.

    Andersen (1996) separate stock prices into fundamental and speculative components and found that only the former has an impact on investment.

  16. 16.

    Refer to Hodrick and Prescott (1997) for full discussion of the technique that estimates an unobservable time trend (growth) component of given time series variable.

  17. 17.

    These target weights depend on the sector parameters.

  18. 18.

    See Charemza and Husssain Shah (2013) for detailed discussion of the methodology.

  19. 19.

    We used 1 lag for both countries to estimate the VAR as suggested by the Akaike information criteria.

  20. 20.

    We use relative sector prices not individual price level. This addresses the issue of non-stationarity.

  21. 21.

    Results for the unit root test are not reported, but available on request.

  22. 22.

    Empirical estimations have been done using optimization module OPTMUM of GAUSS, version 13.

  23. 23.

    See Table 3.

  24. 24.

    The strong assumption yields results that are fundamentally similar to the ones obtained with the assumption of \(\Psi _{m} = 0.5\) for stock prices. This corroborates the robustness of the obtained results.

  25. 25.

    Although both countries implement IT regimes, they do differ in some economic policies and relative importance of the stock market to their GDP. For example, the level of their central banks’ independence varies. The Fed has both target and instrument independence while the Bank of England has only instrument independence as the target is defined by the government. In addition, some sectors also differ as Dubois et al. (2014) document, in that some of the countries’ commodity demand structures varies, in particular, their food demand structure. This seems credible as it is obvious that their sector prices respond differently to the output gap changes.

  26. 26.

    In contrast, if asset prices were decreasing faster than the other prices then the central bank could have reacted by cutting down the interest rate.


  1. Abo-Zaid S, Tuzemen D (2012) Inflation targeting: a three-decade perspective. J Policy Model 34(5):621–645

    Article  Google Scholar 

  2. Alchian A, Klein B (1973) On a correct measure of inflation. J Money Credit Bank 5(1):173–191

    Article  Google Scholar 

  3. Al-Khazali OM, Pyun CS (2004) Stock prices and infalation: new evidence from the Pacific-Basin countries. Rev Quant Financ Acc 22(2):123–140

    Article  Google Scholar 

  4. Andersen M (1996) Share prices and investment. Economic Research Department, Sydney, Reserve Bank of Australia, Discussion paper no. 9610

  5. Aoki K (2001) Optimal monetary policy responses to relative-price changes. J Monet Econ 48(1):55–80

    Article  Google Scholar 

  6. Bernanke B, Gertler M (1999) Monetary policy and asset price volatility. Econ Rev 84(4):17–51

    Google Scholar 

  7. Bernanke B, Gertler M (2001) Should central banks respond to movements in asset prices? Am Econ Rev 91(2):253–257

    Article  Google Scholar 

  8. Blanchard O, Rhee C, Summers L (1993) The stock market, profit, and investment. Q J Econ 108(1):115–136

    Article  Google Scholar 

  9. Bordo M, Jeanne O (2002) Monetary policy and asset prices: does ‘Benign Neglect’ make sense? Int Finance 5(2):139–164

    Article  Google Scholar 

  10. Bordo M, Wheelock D (2006) When do stock market booms occur? The macroeconomic and policy environments of 20th century booms. Federal Reserve Bank of St. Louis, St. Louis, MO, working paper no. 2006-051A

  11. Cecchetti S, Genberg H, Lipsky J, Wadhwani S (2000) Asset prices and central bank policy. International Center for Monetary and Banking Studies Published by ICMB and the CEPR, Geneva

  12. Charemza W, Husssain Shah I (2013) Stability price index, core inflation and output volatility. Appl Econ Lett 20(8):737–741

    Article  Google Scholar 

  13. Clarida R, Galí J, Gertler M (1999) The science of monetary policy: a new Keynesian perspective. J Econ Lit 37(4):1661–1707

    Article  Google Scholar 

  14. Clarida R, Galí J, Gertler M (2000) Monetary policy rules and macroeconomic stability: evidence and some theory. Q J Econ 115(1):147–180

    Article  Google Scholar 

  15. Clarida R, Galí J, Gertler M (2001) Optimal monetary policy in open versus closed economies: an integrated approach. Am Econ Rev 91(2):248–252

    Article  Google Scholar 

  16. Dubois P, Griffith R, Nevo A (2014) Do prices and attributes explain international differences in food purchases? Am Econ Rev 104(3):832–867

    Article  Google Scholar 

  17. Fischer S (1977) Long-term contracts, rational expectations, and the optimal money supply rule. J Polit Econ 85(1):191–205

    Article  Google Scholar 

  18. Goodhart C (2001) What weight should be given to asset prices in the measurement of inflation? Econ J 111(472):335–356

    Google Scholar 

  19. Goodhart C, Hofmann B (2000) Do asset prices help to predict consumer price inflation? Manch Sch 68(s1):122–140

    Article  Google Scholar 

  20. Hamilton JD (2009) Causes and consequences of the oil shock of 2007–08. Brook Pap Econ Act 2009(1):215–261

    Article  Google Scholar 

  21. Hilliard JE, Hilliard J (2015) A comparison of rebalanced and buy and hold portfolios: does monetary policy matter? Rev Pac Basin Financ Mark Policies 18(1):155006

    Article  Google Scholar 

  22. Hodrick R, Prescott E (1997) Postwar U.S. business cycles: an empirical investigation. J Money Credit Bank 29(1):1–16

    Article  Google Scholar 

  23. Hsing Y (2011) Impacts of macroeconomic variables on the U.S. stock market index and policy implications. Econ Bull 31(1):883–892

    Google Scholar 

  24. Kaufmann D, Lein-Rupprecht S (2011) Sectoral inflation dynamics, idiosyncratic shocks and monetary policy. Swiss National Bank, Zurich, working paper no. 2011-7

  25. Kent C, Low P (1997) Asset-price bubbles and monetary policy. Reserve Bank of Australia, discussion paper no. RDP9709

  26. Kolluri B, Wahab M (2008) Stock returns and expected inflation: evidence from an asymmetric test specification. Rev Quant Financ Acc 30(4):371–395

    Article  Google Scholar 

  27. Kurozumi T (2012) Sustainability, flexibility, and inflation targeting. Econ Lett 114(1):80–82

    Article  Google Scholar 

  28. Laopodis NT (2010) Dynamic linkages between monetary policy and the stock market. Rev Quant Financ Acc 35(3):271–293

    Article  Google Scholar 

  29. Lee B (2003) Asset returns and inflation in response to supply. Monet Fisc Disturb Rev Quant Finance Acc 21(3):207–231

    Article  Google Scholar 

  30. Lütkepohl H (1993) Introduction to multiple time series analysis. Springer, Berlin

    Book  Google Scholar 

  31. Mankiw N, Reis R (2002) Sticky information versus sticky prices: a proposal to replace the new Keynesian Phillips curve. Q J Econ 117(4):1295–1328

    Article  Google Scholar 

  32. Mankiw N, Reis R (2003) What measure of inflation should a central bank target? J Eur Econ Assoc 1(5):1058–1086

    Article  Google Scholar 

  33. Matalík I, Skolkova M, Syrovatka J (2005) Real estate prices and CNB monetary policy. Bank Int Settl 21:184–196

    Google Scholar 

  34. Ogaki M (1993) Generalized method of moments: econometric applications. In: Maddala GS, Rao CR, Vinod HD (eds) Handbook of Statistics, vol 11. Elsevier, North Holland, pp 455–488

  35. PWC (2013) Are stock markets reliable leading indicators of the real economy for the US and the UK?

  36. Romer D (2012) Advanced macroeconomics. McGraw-Hill/Irwin, New York

    Google Scholar 

  37. Schwartz A (2003) Asset price inflation and monetary policy. Atl Econ J 31(1):1–14

    Article  Google Scholar 

  38. Shiratsuka S (1999) Asset price fluctuation and price indices. Monet Econ Stud 17(3):103–128

    Google Scholar 

  39. Svensson L (1999a) Inflation targeting as a monetary policy rule. J Monet Econ 43(3):607–654

    Article  Google Scholar 

  40. Svensson L (1999b) Inflation targeting: some extensions. Scand J Econ 101(3):337–361

    Article  Google Scholar 

  41. Svensson L (2002) Inflation targeting: should it be modeled as an instrument rule or a targeting rule? Eur Econ Rev 46(4–5):771–780

    Article  Google Scholar 

  42. Svensson L (2010) Inflation targeting. In: Friedman BM, Woodford M (eds) Handbook of monetary economics, vol 3, 22nd edn. Elsevier, Amsterdam, pp 1237–1302

  43. Wooldridge J (2001) Applications of generalized method of moments estimation. J Econ Perspect 15(4):87–100

    Article  Google Scholar 

Download references


We are indebted to the anonymous reviewer and the editor, C. F. Lee for the constructive and helpful comments. We are grateful to Wojciech Charemza and Carlos Diaz Vela for assistance in programming. We also acknowledge the helpful comments received from Ricardo Reis, John Hudson and Bruce Morley.

Author information



Corresponding author

Correspondence to Imran Hussain Shah.



See Tables 5 and 6.

Table 5 Correlation matrix of shock for UK
Table 6 Correlation matrix of shock for US

Rights and permissions

Reprints and Permissions

About this article

Verify currency and authenticity via CrossMark

Cite this article

Shah, I.H., Ahmad, A.H. How important is the financial sector to price indices in an inflation targeting regime? An empirical analysis of the UK and the US. Rev Quant Finan Acc 48, 1063–1082 (2017).

Download citation


  • Stock prices
  • Output stability index
  • Inflation targeting
  • Fundamental
  • Bubbles

JEL Classification

  • D53
  • E31
  • E58
  • G12