On the Asymmetric U-Shaped Relationship between Inflation, Inflation Uncertainty and Relative Price Skewness in the UK

Abstract

We investigate asymmetries in the relationship between the cross-sectional mean (aggregate) rate of inflation and the second and third central moments of the cross-sectional distribution of relative prices by means of a modified Calvo pricing model with regime-dependent price rigidities. We assume that price rigidity is more pronounced when price exceeds marginal cost, a situation that we identify with weak competition and market power. Calibration experiments using realistic parameterisations reveal that the inflation-standard deviation and inflation-skewness relationships exhibit pronounced U-shaped asymmetries around the historical mean rate of inflation. UK sectoral inflation data supports our results, and indicates that our inclusion of regime-switching rigidities is important in providing an accurate characterisation of the higher moments of the distribution of sectoral price changes. We conclude that monetary policy should be designed to exploit these U-shaped relationships by targeting a level of inflation proximate to the (common) turning point. Furthermore, we conclude that core inflation measures should not be used for policy purposes as they exclude much of the information contained in the higher moments of the distribution of price changes.