Should Inflation-Targeting Central Banks Care about Traded and Non-Traded Sectors?

Business cycles are rarely fully synchronized across sectors. This may be a result of asymmetric shocks, or divergent responses to symmetric shocks, such as monetary policy shocks. If there is imperfect risk-sharing across sectors, there is an argument for letting the central bank stabilize employment and production in each sector separately, instead of aggregate employment and production. This paper argues, however, that doing so may in fact be counterproductive. The reason is that the forward-looking variables, in particular the exchange rate, produce a policy imperfection under discretion. By targeting each sector separately, the central bank may be more exposed to this policy inefficiency. In particular, the inefficient use of the exchange-rate channel results in a stabilization bias, where the non-traded sector is stabilized too much and the traded sector too little.