Decomposing the rate of inflation: price-setting and monetary policy

This paper investigates the domestic transmission dynamics of consumer prices by decomposing the Consumer Price Index (CPI) into sectoral components for the US, UK, and Japan from January 1988 (January 1993 for the US) to March 2025. Using a Time-Varying Parameter Vector Autoregression (TVP-VAR) connectedness framework, we quantify the extent and evolution of inflation spillovers across sectors. We find that inflation is increasingly shaped by endogenous interactions across sectors, with substantial variation in spillover intensity across countries and periods. Inflation connectedness rose sharply post-2021 in the US and UK, while Japan’s inflation network remained less integrated. Our findings reveal that domestic price coordination, not just external shocks or monetary policy, plays a key role in inflation dynamics. This has important implications for central banks, suggesting that sectoral behavior and network effects must be considered alongside traditional macroeconomic indicators when designing effective inflation-targeting monetary policy strategies.