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The Natural Rate of Inflation

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  • Engin Kara

Abstract

I identify the natural rate of inflation: the threshold where signal-to-noise crosses unity. Extending Lucas (1972), I show that when inflation falls below sectoral volatility, firms cannot distinguish aggregate from idiosyncratic shocks. Sticky-price firms rationally filter out competitor price movements, creating endogenous stability. When inflation exceeds the natural rate, filtering ceases, coordination increases, and inflation becomes self-reinforcing. Using six million UK micro-price observations, I estimatethis threshold at 1.9%. Crossing it triggers a regime shift: price dispersion falls 10%, inflation persistence jumps from near-zero to 0.44, and monetary policy loses traction. These findings validate 2% targets as the limit of self-correction.

Suggested Citation

  • Engin Kara, 2025. "The Natural Rate of Inflation," CESifo Working Paper Series 12306, CESifo.
    • Handle: RePEc:ces:ceswps:_12306
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    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets

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