Inflation is the main topic of macro discussion right now, with price increases exceeding expectations, even after accounting for the additional shocks. As usual, the media focus is on the situation in the U.S., but the phenomenon is pretty much global This means that other countries can offer us some clues on the nature of the phenomenon.
One such country is Czechia, which combines features that
make it an interesting learning case. On one hand it is a country with firmly
established inflation targeting, so that it is not plagued by the regular
instability of inflation expectations that haunt many emerging markets. This
means that its experience is relevant for central banks in developed economies,
unlike experience in, say, Brazil or Turkey. On the other hand, it is a small
open economy with significant focus on industrial production. This means that its
experience is not only sufficiently different from US or euro zone, but that it
is more exposed to current sources of inflationary pressures than these
countries.
So what is the recent inflationary development in Czechia?
Simply, inflation is running amok: prices have increased by around 1% in each of
the last 4 months. That is, increase of
4% in span 4 month. Or to put in yet another way, it is the increase central
bank desires in a two-year period occurring in four months. While the sources
are to some degree global, such large increase cannot be explained by these
factors alone. And before one jumps into conclusion that this is result of
domestic policy mismanagement, it is important to note that the government
support for the economy was not abnormal – apart from decrease in income tax
benefiting mostly the rich – and that the economy is actually doing quite badly
relative to its peers.
So what is the lesson here? This is speculative, but one way
to think about the situation is in terms of what we know about the incentives
for price setting. Increasing prices is in its nature a coordination game: each
firm does not want to raise its prices in order not to lose customers to its
competitors. This is what lies behind sluggishness of price adjustment in economic
models.
But what if everybody knows that everybody will be increasing
prices because of spike in input prices such as commodity prices, energy
prices, component prices etc.? Well, if price setters know that their competitors
will be increasing prices now, and that they will need to increases prices
relatively soon anyways, then they might as well decide to increase prices
right away. After all, higher prices are less likely to be noticed in environment
when everybody is increasing prices.
This means that the rapid price growth might be result of
coordinated equilibrium: everybody increasing prices because they observed public
signal that everybody will be increasing prices. And as such, some of the price
increases we are seeing might be prices increases brought forward, causing
inflation to spike more than one would expect. In other words, we might be
seeing a year worth of price increases crammed into several month in which everybody
expected everybody to hike prices.
This means two things. First, in the short term inflation is
likely to surprise on the upside even more, with other price setters jumping on
the inflationary bandwagon. Second, the inflation might drop relatively quickly:
once the period of rapid price increases is over, further price increases might
not be forthcoming, since they have been brought forward. In some sense, we
will have reached the natural level of prices, just in different path, with
rapid inflation followed by quick slowdown in inflation, rather than gradual
rise we are used to. Of course, the second observation applies only if the inflation
does not cause change in inflation expectations, in which case rapid inflation could
start to feed on itself.
This pattern might even fit the historical experience: it
seems that commodity-driven inflationary periods which did not result in shift
in inflation expectations are often followed by long periods of subdued inflation.
Most recent example is the example of inflationary spike in 2011, and long
years of low inflation afterwards.
P.S.: Note that this is one example of why the Calvo pricing
is so not up to the task: it does not allow firms to choose when to change
their prices, only by how much, and hence does not allow for coordinate price
increases.
P.P.S.: In terms of time series modelling, this would
suggest that the price level, not just its part rate of change, is important.
Or alternatively, that there are more regimes in inflation.
P.P.P.S.: There is a notion of attention-driven inflationary
behavior in here: maybe individual price rises are less likely to be noticed
when they are done in environment of many prices rising.
