Consumption categories, household attention, and inflation expectations: Implications for optimal monetary policy

Abstract

What inflation measure should central banks target? This paper highlights a mechanism where monetary policy optimally targets headline inflation if households pay limited attention to different consumption categories when forming inflation expectations. This result stands in contrast to standard rational expectations models, where optimal policy targets core inflation. The core inflation rate excludes volatile energy and food prices (non-core) from headline inflation. Using novel survey data on inflation expectations for disaggregated consumption categories, I find household expectations are disproportionately driven by beliefs about future non-core prices. A model of bounded rationality accounts for the empirical evidence. While forming inflation expectations, households pay more attention to the volatile non-core components. Embedding this framework into a multi-sector New Keynesian model, I show that targeting headline rather than core inflation provides welfare gains.