The Macroeconomic and Welfare Effects of Targeted Inflation Support Packages

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We evaluate the welfare effects of targeted fiscal responses to inflationary shocks, such as sector-specific subsidies and household-specific transfers. We do so in a multi-sector New Keynesian model nesting a flexible heterogeneous-household block, matched one-for-one to distributional data. We derive a micro-founded welfare loss function that decomposes into macroeconomic and distributional components, as well as into partial- and general-equilibrium effects. Social preferences for distributional fluctuations are disciplined using observed tax and transfer policies over the business cycle. Applying this framework to the UK’s 2022 cost-of-living package, which combined an energy price cap with targeted transfers, we obtain three findings. First, the package reduced welfare, with a large role for macro channels. Second, a dominant channel was an unintended redistribution, with large welfare losses borne by higher-income but heavily indebted households, who were negatively affected both by rising interest rates and by tax increases required to finance the package. Third, the standard central bank practice of “looking through” the mechanical effects of the energy price cap on CPI inflation amplified these losses rather than mitigating them.