World Commodity Prices as a Forecasting Tool for Retail Prices - Evidence from the United Kingdom

During the 1990s, several countries have adopted a monetary policy framework based on explicit inflation targets. The U.K. authorities introduced an inflation target in September 1992, following the exit of the sterling from the ERM, on the basis of inflation projections published quarterly. Among the information variables taken into account by the Bank of England in assessing the inflation outlook are developments in world commodity prices. While the literature gives several economic reasons for using world commodity prices as a guide for monetary policy, other authors have highlighted their weaknesses, such as their inherent volatility. The empirical evidence, conducted mainly for the United States, is mixed. Although some authors find evidence in favor of using world commodity prices as a monetary policy tool, others find a relationship but no intertemporal causation. More recent studies do not seem to find a clear and reliable relationship between commodity and retail prices. In the context of the United Kingdom new monetary framework of inflation targeting, this paper investigates whether world commodity prices may be a useful forecasting tool for inflation in the United Kingdom. Using cointegration and Granger-causality techniques, the paper assesses whether a stable long-run co-movement exists between world commodity prices and United Kingdom retail prices, and whether short-run changes in world commodity prices convey information about future movements in United Kingdom retail prices. The results show noncointegration and no unidirectional Granger causality from commodity to retail prices. These findings suggest that the United Kingdom monetary authorities may have little to gain from using developments in commodity prices to forecast movements in retail prices in the inflation targeting framework they are currently following.