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Inflation Persistence Network (IPN): Brief summary: Inflation Persistence and Price Setting Behaviour in the Euro Area

The Eurosystem Inflation Persistence Network (IPN) has conducted an in-depth study on inflation persistence and price stickiness in the euro area. Inflation persistence has immediate consequences for conducting monetary policy. For example, the appropriate response to shocks depends on the degree to which inflation is persistent. While it is the properties of aggregate inflation that are eventually of interest for policy making, an important factor underlying the way inflation behaves over time are the features and determinants of the behavioural mechanisms underlying price setting.

For that reason, the IPN has availed itself of an unprecedented data set, covering a large amount of information at the macroeconomic, sectoral and micro (individual firm) level. This information includes price records underlying the construction of both consumer and producer price indices and surveys on price setting behaviour. The IPN has been a collaborative endeavour of all NCBs of the Eurosystem and the ECB. The joint efforts of all participants have advanced the knowledge of inflation dynamics and their determinants in the euro area considerably. The main conclusions drawn from the IPN are the following:

Under the current monetary policy regime the estimated degree of inflation persistence in the euro area is moderate

While estimates of the degree of inflation persistence in the euro area over long time samples find that inflation behaves in a very persistent fashion, this result needs to be qualified substantially when looking at the current monetary policy regime. Long sample periods cover several monetary policy regimes, which often are characterised by different values of average inflation. Accordingly, the changes in regimes have brought about long-lasting changes in average inflation, which should not be mistaken for inflation persistence in response to other disturbances. Accounting for changes in monetary policy regimes either by restricting the sample to cover the current policy regime or by allowing for statistically significant changes in the mean of inflation, most studies arrive at the conclusion that inflation (measured as quarter-on-quarter inflation) is only moderately persistent. Moreover, there is some evidence that the degree of inflation persistence may have fallen over the last decade. There is, however, a considerable degree of uncertainty surrounding those estimates, which typically also depend on the inflation index used.

An important explanatory factor behind this moderate degree of inflation persistence is the anchoring of inflation expectations of economic agents. By conducting monetary policy such that inflation expectations of economic agents are well anchored, the central bank can ensure that actual inflation does not deviate for too long, and in a too persistent fashion from what it has announced as its medium-run objective for inflation. In economies where central banks have adopted explicit inflation objectives, long-run inflation expectations have been successfully anchored, and as a result inflation expectations are much less dependent on past inflation and actual inflation developments are less persistent.

In order to continue to benefit from reduced inflation persistence, the central bank needs to ensure that inflation expectations remain anchored to the inflation objective. This allows the central bank to take a medium-term orientation as agents see through the temporary nature of various cost-push shocks. On the other hand, when a series of cost-push shocks in one direction risks increasing the perceived degree of persistence by the private sector, inflation expectations and inflation itself could become unanchored and costly to control. If communication by the central bank can not alleviate this problem, it is advisable to respond quite aggressively and persistently to such shocks. Moreover, the large degree of uncertainty surrounding the estimates of inflation persistence, suggest that policymakers might want to be cautious and assume a relatively high degree of inflation persistence, resulting in a stronger response to inflationary disturbances rather than take the risk of assuming a too low degree of inflation persistence. This way, policy can insure against the risk that an initial shock is factored into the expectations of agents and will lead inflation to drift away at lower welfare cost.

Greater price stickiness in the retail sector in the euro area than in the US

The micro evidence of the IPN shows that prices change infrequently. Prices in sectors covered by the consumer price index are unchanged on average for 4 to 5 quarters. The frequency of price changes is somewhat lower in the retail sector compared to the producer sector, where the median firm changes its price once a year. This finding implies that prices in the consumer sector are substantially more sticky in the euro area than in the United States, where consumer prices have been found to change twice as often, i.e. every two quarters.

Price stickiness can arise due to various reasons. On the one hand, in a stable macroeconomic environment, where agents trust in price stability, there is less need to change prices. On the other hand, there might be structural inefficiencies that can prevent firms from changing prices. According to the price setting surveys, the most important reasons that prevent immediate price adjustment are i) long-run relationships with customers, ii) explicit contracts which are costly to re-negotiate; and iii) coordination problems arising from the fact that firms prefer not to change prices unless their competitors do so. Menu costs and costs of gathering information are reported to be less important. The reasons for the difference in the degree of price stickiness in the retail sector between the euro area and the United States are unclear and may be due to a number of factors such as differences in measurement, differences in the importance of long-run relationships, differences in the variability of the underlying costs such as wages and differences in the degree of competition.

Clearly, the monetary policy implications of the greater degree of price stickiness in the euro area will depend on the source of the price stickiness. Some tentative implications can, however, be drawn. With prices being more sticky, inflation will not respond to developments in marginal costs and/or the output gap to the same extent and at the same pace as in an economy with flexible prices. Accordingly, stabilising inflation will be more costly in terms of output losses: for a targeted reduction in inflation, output needs to be reduced by more than in the case of flexible prices. Since inflation variability is more costly in such a case, monetary policy is well advised to put larger weights on reducing inflation variability relative to output variability. At the same time, a higher degree of price stickiness also reduces the impact of cost-push shocks on inflation.

There is significant sectoral heterogeneity in the degree of price stickiness

The micro evidence of the IPN also shows that there is a substantial degree of heterogeneity in the degree of price stickiness across products. Price changes are very frequent for energy and unprocessed food, while they are relatively infrequent for non-energy industrial goods and particularly services. Beyond such heterogeneity across product categories, there is also substantial heterogeneity of price-setting behaviour within product categories.

Various factors may drive this heterogeneity. One important factor is the variability of the input costs. For example, it has been found that prices change less frequently for products with a larger share of labour input and with a smaller share of intermediate energy inputs. This suggests that persistence in wage developments can be a cause for price stickiness. The IPN has also uncovered some evidence that larger competition reduces price stickiness. For example, consumer prices are changed more often in supermarkets and hypermarkets compared to higher-priced corner-shops. Furthermore, the survey results have shown that firms in highly competitive markets respond more strongly to changes in underlying factors. Structural reforms to enhance competitiveness in labour and product markets might therefore help in reducing the importance of price stickiness. At the same time, it is also important to note that price stickiness need not necessarily be undesirable, e.g. if consumers prefer to purchase their goods in retail outlets that change prices less frequently, and particularly if retailers follow a pricing strategy of keeping prices fixed at a low level.

The economic literature has suggested that in the case of sectoral heterogeneity of price stickiness the central bank should target a price index that assigns larger weights to units where price developments are more sticky. In the light of the IPN results, this would point to giving more prominence to a measure of HICP inflation excluding energy and unprocessed food. The medium-term orientation of the ECB’s monetary policy strategy allows for looking through the short-term effects of changes in flexible energy and food prices and concentrating on the more persistent components of the HICP without the need to change the index used in the definition of price stability. Using a modified HICP index as the underlying measure for the ECB’s definition of price stability would have several drawbacks related to a lack of transparency, difficulties in communication and the possibility of creating perverse incentives. Nonetheless, in order to assess the effect of a given shock on the future path of inflation, it is important for the central bank to take into account information on the source and nature of economic shocks, as well as to understand the degree of nominal stickiness of the sector or region hit by those shocks, even if it formulates its policy with a view to maintaining price stability for the currency area as a whole.

Price decreases are not uncommon

The micro evidence of the IPN shows that price decreases are not uncommon, with the notable exception of services. On average, around 40% of price changes are price reductions (whereas in services, this number stands at 20%). Looking at the magnitude of price changes, it turns out that price increases as well as decreases are sizeable compared to the inflation rate. The average consumer price increase is found to be in the order of 8%, and the average price decrease slightly larger at 10%.

The finding that overall price falls are very common has important implications for the optimal inflation objective. It has been argued that downward nominal price rigidities that are not matched by similar upward rigidities may justify a higher inflation objective in order to facilitate relative price adjustments. The IPN findings do not suggest that this is an important reason for such an inflation buffer. However, the exception of services is important in this respect, given its large weight in the HICP and the fact that services are largely non-tradable. To the extent that the services sector has a relatively large labour input share, another possible reason for its downward price rigidity is downward nominal wage rigidity, which in itself could be a relevant factor for maintaining an inflation buffer.

There is ample evidence of state-dependence in price setting behaviour in the euro area.

The IPN has produced a wealth of information on price setting and inflation dynamics in the euro area. Some of the IPN findings on price setting practices challenge several of the assumptions currently used in micro-founded macroeconomic models of inflation dynamics. For example, in contrast to the assumption made in the most popular inflation models that firms only change their price as a function of time and in a staggered fashion, the IPN has uncovered ample evidence of state-dependence in price setting. The frequency of price changes depends on economic developments such as changes in VAT rates, the level of aggregate and sectoral inflation and collective wage agreements. Moreover, the large average size of price changes suggests that idiosyncratic shocks at the firm level are also important. This finding is corroborated by the survey results, where firms were directly asked about their price-setting rules.

Implicit and explicit contracts are ranked by firms as the most relevant explanation for price stickiness.

The surveys conducted by the IPN contained, among others, the following question: “If there are reasons for changing the price of your main product, which of the following factors may well prevent an immediate price adjustment?” The list following this question offered a series of statements, expressed in simple terms, based on different economic theories of price rigidities. The respondents could indicate their degree of agreement with each statement, choosing among four categories: unimportant (1), of minor importance (2), important (3) and very important (4), where the numbers in brackets indicate the scores attached to each category. Implicit and explicit contracts, cost-based pricing and co-ordination failure are the most relevant explanations for sticky prices, while menu costs, pricing thresholds and costly information are not recognised as important by the respondents. The theory of implicit contracts is based on the idea that firms establish long-run relationships with customers in order to make future sales more predictable; in other words, they try to win customer loyalty simply by changing prices as little as possible. “Explicit contracts” (firms have to re-negotiate a contract to change their prices) as an explanation for sticky prices is the second most important factor at the euro area level (with an average score of 2.6). The same average score is attributed to “cost-based pricing”, which assumes that prices do not change if costs do not change or that they respond only with a lag to cost changes. In the case of “co-ordination failure”, which earns an average score of 2.4, the idea is that firms prefer not to change their prices unless one of their competitors moves first. If a firm is the only one to increase its price after a shock, it may lose customers; on the other hand, a single-handed price reduction might spark off a price war, which could in the end be detrimental to the firm's profits. Without a co-ordinating mechanism that allows firms to move together, prices may remain fixed.