Testing for Explosive Behaviour in Relative Inflation Measures: Implications for Monetary Policy

In this paper we test for large deviations in headline measures of the price level relative to core measures using the recently proposed test of Phillips et al. (2011a). We find evidence of explosive behaviour in the headline price index of personal consumption expenditures (PCE) relative to the core PCE (less food and energy prices) on three occasions from 1982-2010. Two of these episodes correspond to energy supply shocks (OPEC price collapse of 1986 and Hurricane Katrina). The third one is during March 2008 through September 2008 which seems to be driven by both food and energy prices as these indices exhibit explosive behaviour. We also find evidence suggesting that inflation expectations behave differently under normal and explosive periods. In particular, unemployment and interest rates also help predict inflation expectations during explosive episodes relative to normal times. Furthermore, explosive episodes in the relative measure between headline and core inflation is found to be more important than the relative volatile periods implied by a Markov-switching model when studying inflation expectations. The findings of this paper suggest that explosive behaviour of headline versus core PCE should be taken into account when conducting monetary policy as it is a key determinant in consumers’ inflation expectations.