Firms React More To Recent Inflation Than Expected Future Inflation
To better understand the price-setting behaviour of firms, new research by the Reserve Bank of New Zealand looked at how well two kinds of measures of price-setting behaviour – from surveys and from models based on recent data – help explain actual inflation.
'When explaining and forecasting domestic or non-tradables inflation, modelled measures of price-setting behaviour perform better than survey-based measures,' the Analytical Note authors Ross Kendall and Marea Sing say.
Modelled measures that are more sensitive to recent inflation are better for forecasting domestic or non-tradable inflation than those that are not, the research found.
In other words, businesses are more likely to change their prices based on the inflation they experienced recently, rather than the inflation they experienced several years ago. Recent inflation also has more influence on price setting behaviour than expectations of future inflation.
However, the various measures of price-setting behaviour are not significantly different from each other and it is best to consider all measures when explaining and forecasting inflation. This is especially true as price-setting behaviour can change over time.
This research can help the Monetary Policy Committee make judgements about the inflation outlook and where to set the Official Cash Rate.
'These judgements about price-setting behaviour are particularly important following episodes of high or low inflation, as they influence how persistent the effects of these periods will be and how quickly inflation is likely to return to the 2% target midpoint,' the Note says.
Notes:
Analytical Note key findings
Price-setting behaviour describes how firms dynamically adjust their prices based on past and expected future inflation. Price-setting behaviour plays a key role in the inflation process, in particular, influencing how persistent inflation tends to be.
We can use 'survey measures' (inflation expectations of households and firms) or 'modelled measures' (such as those calculated as a function of past inflation outcomes) to summarise the influence of price-setting behaviour on inflation in our models.
Given the large increase and subsequent decline in inflation in recent years, we have updated and extended our previous research on price-setting behaviour. In line with the original research, our updated analysis suggests that when explaining and forecasting non-tradables inflation, modelled measures of price-setting behaviour perform better than survey measures.
We find that modelled measures that are relatively sensitive to recent inflation data generally perform better than one that is less sensitive to recent inflation data.
The results on the relative strengths of the range of measures of price-setting behaviour considered in this paper can help the Monetary Policy Committee (MPC) to inform judgements about the outlook for inflation. These judgements about price-setting behaviour are particularly important following periods of high or low inflation, as they influence how persistent the effects of these periods will be on future inflation.
The differences in performance that we find between measures are relatively small, which reinforces the need to monitor a range of measures.
Why we did this research
Price-setting behaviour plays a key role in determining how past and expected inflation influence inflation today. This research helps us to see which methods of estimating price-setting behaviour can improve our understanding of inflation the most.
Improving our understanding of what drives inflation helps us to understand the outlook for inflation over the medium term. This in turn helps the Monetary Policy Committee to set monetary policy so that inflation is within their 1 to 3% target range over the medium term.
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