The Natural Rate of Inflation

Engin Kara

No 12306, CESifo Working Paper Series from CESifo

Abstract: I identify the natural rate of inflation: the threshold where signal-to-noise crosses unity. Extending Lucas (1972), I show that when inflation falls below sectoral volatility, firms cannot distinguish aggregate from idiosyncratic shocks. Sticky-price firms rationally filter out competitor price movements, creating endogenous stability. When inflation exceeds the natural rate, filtering ceases, coordination increases, and inflation becomes self-reinforcing. Using six million UK micro-price observations, I estimatethis threshold at 1.9%. Crossing it triggers a regime shift: price dispersion falls 10%, inflation persistence jumps from near-zero to 0.44, and monetary policy loses traction. These findings validate 2% targets as the limit of self-correction.

Keywords: inflation targeting; strategic pricing; behavioural thresholds; sectoral volatility; monetary policy; price complementarity (search for similar items in EconPapers)
JEL-codes: D21 E31 E52 E58 L13 (search for similar items in EconPapers)
Date: 2025
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