Unit Roots in Inflation and Aggregation Bias

In this paper, we examine whether UK inflation is characterized by aggregation bias using three sets of increasingly disaggregated inflation data and a battery of univariate and panel unit root tests. Our results support the existence of aggregation bias since while the unit root hypothesis cannot be rejected for aggregate inflation, it can be rejected for some of its sectoral components, with the rejection frequencies increasing when we use more disaggregate data. Results from structural break analysis indicate that monetary policy shifts are the main factor behind breaks in UK inflation. The panel results typically indicate that when sectoral inflation rates are pooled the unit root hypothesis can be rejected. Our results have important implications for applied econometric analysis, macroeconomic theory and for the conduct of monetary policy.