Who’s to blame for sticky prices?

The list of those responsible for sky-high inflation grows ever longer: jammed supply chains, Putin’s invasion of Ukraine, sleeping central bankers, a dearth of workers, bolder pay demands . . . 

Now, a new culprit is at large: our own foolishness.

Research by Vania Esady at the Bank of England — catchily titled Real and nominal effects of monetary shocks under time‑varying disagreement — provides a neat link between our struggles to make sense of the economic “polycrisis” we are in, and the persistence in price growth.

At the heart of most macroeconomists’ models are rational economic actors. But how can anyone be straight-thinking when there is so much uncertainty? And what does that mean for inflation-fighting central bankers?

Esady uses the range of GDP projections from the US Survey of Professional Forecasters as a proxy for high “information frictions” in assessing current economic conditions. In a Bank Underground blog post accompanying the paper:

. . . because significant disagreement indicates that it is difficult to observe current economic conditions . . . If the ability to nowcast varies over time, this may affect agents’ ability to respond to various shocks, including monetary policy shocks.

(NB: That’s a pretty conservative bar: if professional forecasters cannot agree, then you would expect an even higher level of confusion among business and households.)

She finds that when disagreement is higher — ie when there are more difficulties in inferring current economic conditions — contractionary monetary policy brings down inflation at the cost of a greater fall in economic activity.

Why? The answer could lie in “rational inattention”, or, our finite information-processing capacity. When there is more uncertainty and distractions abound it is time-consuming to find answers.

It is also difficult to set a price when it is a challenge simply ascertaining how strong demand is or will be. So if, as a seller, you’re unsure whether to lower prices to get ahead of demand falling, it’s tempting to stick rather than twist:

In periods where information frictions are severe, price-setting firms pay less attention to demand conditions. This implies that their prices will respond sluggishly to monetary policy shocks. The slower prices respond, the more ‘sticky’ prices appear. Stickier prices lead to smaller price adjustments. In conjunction with higher nominal rigidities, this inertia in price adjustments leads to a flatter Phillips curve, yielding larger effects of monetary policy on output.

That is a pretty pertinent finding as economists try to dissect the current stubbornness in underlying inflation — and how much higher central bankers will need to take interest rates (now complicated by Silicon Valley Bank’s collapse). There is plenty of disagreement on the macroeconomic outlook today.

Measures of uncertainty — like the global economic policy uncertainty index — are still elevated. In the UK, the Bank of England’s Decision Maker Panel Survey shows that uncertainty around the outlook for businesses’ expectations for their own-price growth remains at historically high levels.

Clearly communications by central banks — and other institution’ — can help businesses and households to assess economic conditions. But that’ll be tough as SVB’s collapse clouds the outlook even further.

Uncertainty may not be a driving factor behind inflationary persistence, but Esady’s research is a reminder that freakish economic outcomes cannot solely be explained by logical economic phenomena — particularly when economic agents at the heart of it cannot explain it themselves.