World food prices and monetary policy

How should monetary policy respond to large fluctuations in world food prices? We study this question in an open economy model in which imported food has a larger weight in domestic consumption than abroad and international risk sharing can be imperfect. A key novelty is that the real exchange rate and the terms of trade can move in opposite directions in response to world food price shocks. This exacerbates the policy trade-off between stabilizing output prices vis a vis the real exchange rate, to an extent that depends on risk sharing and the price elasticity of exports. We characterize implications for dynamics, optimal monetary policy, and the relative performance of practical monetary rules. While CPI targeting and expected CPI targeting can dominate PPI targeting if international risk sharing is perfect, even seemingly mild departures from the latter make PPI targeting a winner. •We study monetary policy when imported food price shocks are substantial.•We allow for incomplete international risk sharing à la Schulhofer-Wohl (2011).•The real exchange rate and the terms of trade can move in opposite directions, which is novel.•We characterize Ramsey and natural allocations, as well as optimal policy under sticky prices.•Trade-offs between policy rules hinge on exports price elasticity and financial frictions.