Why Inflation is not falling

There has been considerable interest in the recent IMF study that found that the responsiveness of inflation to the output gap (or equivalent measure) falls at low levels of inflation. But if the econometrics is right (and Nick Rowe has some cautionary tales here), what is the explanation for this? I start with two standard stories, but then suggest other possibilities that are specific to current financial conditions.

One standard explanation which the paper itself gives is based on the menu cost model of price inertia. The idea is that firms do not change their prices that often because there are costs to making any change (which economists call menu costs, perhaps betraying how often they spend in restaurants rather than buying food in supermarkets), and that often this cost might be higher than any benefit to profits in making a change. If you derive the aggregate relationship between inflation and the output gap from a model of this kind, the coefficient on the output gap will depend on how frequently prices are changed. So if price changes become more infrequent at low levels of inflation, the sensitivity of inflation to the output gap will fall.

Another quite plausible story which has solid empirical backing is that workers particularly resist nominal wage cuts. That actually implies an asymmetry in response rather than a general reduction in sensitivity (if the output gap was positive workers would happily see wages rise), but it will affect the average response in an econometric study that does not allow for asymmetry, and in current circumstances it is an entirely appropriate story.

You might think that enough, but I have a UK-centric reason for wanting more. In the UK, the ‘wages’ Phillips curve does not seem to be showing any reduction in sensitivity - indeed perhaps the opposite (although any additional sensitivity seems to predate the recession). That does not mean workers are not resisting nominal wage cuts, but the overall impact of this has either been small, or has been offset by something else.

The story I want to tell involves firms’ pricing behaviour, and the role of more risk averse banks. Suppose a firm sees demand for its output fall. Its profits are lower, but it calculates that it can reduce that decline in profits by cutting its price, if that price cut increases demand. There are two risks involved in doing this. First, the price cut might raise demand by much less than expected, with the consequence that profits fall further still. Once the firm realises this it can always put prices back up again, but in the short run profits will decline. Second, it may take time for the price cut to feed through into higher demand: those buying competing products may not immediately realise that they should switch. So although profits might rise eventually, they could fall in the short run.

So in both cases, there is a risk that profits in the short run might suffer as a result of the price cut. In normal times firms would be prepared to take those risks, either because the risks are symmetric (maybe demand will increase by more than expected), or because they represent an investment with a positive eventual payoff (as customers switch products). Critically, even if the short run might actually bring losses rather than profits, the firm’s bank will cover the losses because it is taking a long term view.

However, since the financial crisis, the firm may have noticed that the behaviour of its bank has changed. It refused the business down the road any credit, even though by all accounts its difficulties were clearly temporary. Although the firm would like to cut prices in the expectation that this will eventually raise profits, if the price cutting idea does not work out and the bank plays tough that could mean bankruptcy.

The idea is that the aftermath of the financial crisis, by raising the risk of bankruptcy associated with short term losses, has lead to greater price rigidity. In addition, there are two related effects that could actually lead to higher inflation in the short run. First, the firm does not like the fact that it can no longer depend on the bank to cover any short term losses. Who knows what might happen. So although a price increase might reduce profits if sustained (as customers gradually switch), in the short run profits will rise, and that allows the firm to pay off those debts which would otherwise keep its owners awake at night. This is the firm as a precautionary saver. Second, firms might be keeping prices low not because of existing competition, but because of the threat that a new start-up might emerge and steal some of its business. The one silver lining of the financial crisis for existing firms is that new start-ups are much less likely to get any money from the bank, so this diminished threat of new entry allows the firm to safely increase its profit margins.

I have absolutely no evidence that any of this has been happening, or indeed whether these ideas stand up to serious analysis. I don’t know of any papers that have explored the impact of financial frictions of this kind on prices, but that may well be my fault, so please point me to any you know. If there is anything in these ideas, then they caution against interpreting any current rigidity in inflation as evidence against demand deficiency.