Who is to blame for sticky prices?

The list of those responsible for skyrocketing inflation is getting longer: supply chain disruptions, Putin’s invasion of Ukraine, dormant central banks, shortages of workers, tighter wage requirements. . .

Now a new culprit is on the loose: our own stupidity.

Bank of England research by Vania Esadi with a catchy title Real and Nominal Consequences of Monetary Shocks under Time-Varying Disagreements —provides a clear link between our struggle to make sense of the economic “polycrisis” we’re in and sustained price increases.

The models of most macroeconomists are based on rational economic subjects. But how can you think sensibly when there is so much uncertainty around? And what does this mean for inflation-fighting central banks?

Esadi uses the range of GDP forecasts from the US Professional Forecasters Survey as an indicator of high “information friction” in assessing current economic conditions. In the bank underground Blog post covering letter:

. . . because significant disagreements indicate that it is difficult to observe current economic conditions. . . If the ability to predict nowweather changes over time, this may affect the ability of agents to respond to various shocks, including monetary policy shocks.

(Note: this is a fairly conservative bar: if professional forecasters cannot agree, then even higher levels of confusion among businesses and households should be expected.)

She found that when the odds are higher, that is, when there is more difficulty in inferring current economic conditions, contractionary monetary policy lowers inflation by causing a larger fall in economic activity.

Why? The answer may lie in “rational inattention” or in our limited ability to process information. When there are more uncertainties and distractions, it takes a long time to find answers.

It is also difficult to set a price when it is difficult to simply determine how high or how high the demand will be. So if you, as a seller, are unsure whether to cut prices to get ahead of falling demand, it’s tempting to stick with it rather than dodge:

During periods of severe information contention, price-setting firms pay less attention to demand conditions. This means that their prices will react sluggishly to monetary policy shocks. The slower prices react, the more sticky prices become. Tougher prices lead to less price adjustment. Combined with higher nominal rigidity, this inertia in price adjustment results in a flatter Phillips curve, resulting in a greater impact of monetary policy on output.

That’s a pretty apt conclusion as economists try to analyze the current stubbornness of core inflation – and how much higher interest rates central banks will need (now complicated The collapse of the Silicon Valley bank). There is a lot of controversy today about the macroeconomic outlook.

Uncertainty indicators, such as the Global Policy Uncertainty Index, are still elevated. In the UK Bank of England Survey of a group of decision makers shows that uncertainty about the prospects for business expectations regarding the growth of their own prices remains at historically high levels.

Clearly, reports from central banks and other institutions can help businesses and households assess economic conditions. But it won’t be easy, as the collapse of SVB further darkens the outlook.

Uncertainty may not be the driving factor behind inflationary hardiness, but Esadi’s research is a reminder that bizarre economic outcomes cannot be explained solely by logical economic phenomena, especially when the underlying economic agents cannot explain it themselves.