Related Links

• Inflation Expectations and Price Setting Among Fifth District Firms
• Are Firms Factoring Increasing Inflation Into Their Prices?
• How the Pandemic Era Changed Price-Setting
• Statement on Longer-Run Goals and Monetary Policy Strategy

Transcript

Tim Sablik: My guests today are Felipe Schwartzman and Sonya Waddell. Felipe is a senior economist in the Research department of the Richmond Fed whose research focuses on macroeconomic phenomena related to business cycles and spatial economics. Sonya is a vice president and economist at the Richmond Fed whose responsibilities include regional quantitative and qualitative analysis, including the business surveys.

Thank you both for joining me today.

Felipe Schwartzman: Thank you.

Sonya Waddell: Thank you, Tim. It's great to be here.

Sablik: I'm excited to have both of you on the show today to talk about your research into how businesses in the Richmond Fed's Fifth District observed and responded to inflation during the post-pandemic recovery. You've published two Economic Briefs on your findings, one in March 2022 and one this past January. We'll put links to both of those up on the show page.

You start the 2022 brief with a quote from former Fed Chair Alan Greenspan who said, "Price stability is that state in which expected changes in the general price level do not effectively alter business or household decisions." So, my first question is, is this still a good description of how the Fed views price stability today?

Schwartzman: Today, the Fed has a clear definition of price stability in its Statement on Longer-Run Goals and Monetary Policy Strategy that was reaffirmed in the last FOMC meeting. It states that it judges PCE inflation at 2 percent to be consistent with its statutory mandate for price stability. It then says that the committee judges that longer term inflation expectations are well anchored at 2 percent [to] foster price stability.

So, let's parse that. What does anchoring mean? Inflation expectations are anchored if households and businesses are not revising their views about where inflation is based on every piece of news coming from the Fed or the economy at large. But, rather, they trust inflation will eventually return to some long-run target.

Unanchored expectations are a particular way in which price instability may lead to distorted behavior. When expectations are unanchored, firms will set their prices in response to macroeconomic news that they perceive as informative about where inflation is going rather than the fundamentals of their business. This is not a situation you want to be in.

Waddell: I think it's important to be on the same page about what price stability really means. It does not necessarily mean that certain prices like eggs or lumber don't adjust in the face of supply constraints like avian flu or wildfires. That sort of individual price adjustment is exactly what we should see in the face of scarcity. Individual prices will also adjust in the face of higher demand for a particular good or service.

Price stability is not about individual prices, but the entire basket of goods that we consume. Inflation is growth in the price of the entire basket of goods. High inflation or highly variable inflation, or deflation for that matter, can result in spending, saving, and investment decisions that don't promote a well-functioning economy.

Schwartzman: Prices are like the yardstick by which we measure the costs of different goods and services in the economy. This includes wages, which are the prices of labor; rents, which are the prices of housing; and really the prices of any goods that you may buy in a store or that firms buy from each other.

Now, when you measure something, you don't want to focus too much on which yardstick you use. We can measure a house by square feet or square meters, it's still the same house. The important thing is that you are consistent. Unstable prices are a situation in which this yardstick is not consistent. It's changing.

I'll give you an example. In the late '90s, there was a Mars probe that got lost in space because engineers at NASA were using the metric system and the vendor that they were working with was using imperial units. They should have paid attention to the fact that the units were different and that they should adjust for that. But engineers, most of the time, [are] focusing on the substance of what they're trying to build, and not diverting their attention to the details such as unit conversion.

An economy where the prices are constantly changing is one where households and businesses are diverting attention from the important work of managing their daily lives or managing their businesses to following economic news and protecting themselves from inflation.

Also, prices are incentives. If inflation is high and prices get scrambled, you may end up making bad decisions. You'll buy goods which are cheaper just because of inflation, rather than the ones which are more expensive but may be most efficient.

Sablik: You already got into this, but maybe we can dig a little deeper. Why are inflation expectations so important to the success of the Fed's price stability mission?

Schwartzman: I think this is also addressed in the statement of long-term goals. It says there that well-anchored inflation is beneficial because it allows the [Federal Open Market] Committee to keep employment at its maximum level more easily.

Why is that the case? If inflation expectations are well anchored, then businesses are not going to be altering their pricing decisions as much when they see inflation numbers coming up. Say there's a big war in the world where commodity prices go up or supply chain disruptions like we've recently seen. If the Fed judges that these things are transitory — they're not going to be around for long — well, it may judge that it shouldn't be raising interest rates and generating a recession and doing a lot of things in the economy in order to avoid that. They will just let it pass.

This is a good thing, and it will work if inflation expectations are anchored. The moment they become unanchored, that becomes a harder decision. Because if you just let prices increase and you don't do anything about it, people may see that and say "The Fed dropped the ball — they're not really paying attention, they're not really that interested in price stability. I'm going to raise my prices before inflation catches up with me." This tends to become a self-fulfilling prophecy, so you want to avoid something like that happening.

Sablik: One way to gauge price stability is to ask people how much they're paying attention to inflation data, which is something that you did. Starting in 2021, you asked participants in the Richmond Fed's business surveys how closely they followed inflation data. What did you find as inflation rose in the post-pandemic recovery?

Waddell: One of the things that economists and surveyors of firms have found in the last decade, which is consistent with Felipe's responses, is that owners and operators of businesses pay more attention to inflation when it is high, which makes sense. In a world where businesses are trying to figure out how to incorporate a ton of information into their planning, they'll filter out the predictable. When inflation is low and stable, and they expect it to stay low and stable, they'll stop paying as much attention.

When we started asking these questions in 2021, we wanted to first understand if people were going to start paying more attention as inflation rose. Then, does paying more attention change either expectations for inflation or their expectations for their own price changes, or both? This is both an academic question and a practical one. Maybe paying attention is a way to gauge inflation expectations.

What we found is that, indeed, as inflation rose, firms reported paying more attention to aggregate inflation measures like CPI or PCE and were more likely to report that expected inflation was important to how they set their own prices. Interestingly, those firms that were paying more attention also expected higher inflation in the next 12 months.

Sablik: You kind of alluded to this, but did this increased attention to inflation affect the price setting behavior of firms? What about their expectations of future inflation?

Waddell: In short, as inflation rose, so did firms' expectations for future inflation. As inflation has come down in the last year, so have respondents' expectations for inflation. And, as firms' expectations for aggregate inflation rose, so did their expectations for their own price growth.

There are so many things, Tim, that firms need to take into account when they're setting their prices. They have to think about competition and market share, their own input costs and contracts with vendors, the wages that they pay their workers, frictions that they might face changing prices in the future, etc. What we found is that as inflation rose, firms started to pay more attention and started to report inflation expectations being an increasingly important factor in how they set their prices. This is evident both from what they report as important and in the relationship which we see between inflation expectations and price expectations.

However, it's important to remember that all of the other things also matter in how firms set their prices. Even with the highest inflation that we saw in 40 years, the costs that firms expect to see continue to play the most direct role in how they think about pricing.

Sablik: So, what happened when inflation started to cool last year, in 2023?

Schwartzman: When inflation started to cool, we saw some improvement in that fewer firms said that inflation expectations was an important factor in their price setting. We have also seen normalization in average price change expectations from our respondents.

I feel like the latest wave of surveys made me feel like we may have dodged a bullet. We could have found that those signs of unanchoring would have remained much more persistent, even as inflation receded. But at least, so far, that doesn't seem to be the case.

Sablik: How could this kind of survey data help Fed policymakers and their decision making?

Schwartzman: When we devised the special questions, we were looking for a warning signal that inflation expectations were becoming unanchored. As long as inflation expectations are anchored, the Fed can afford to let the inflationary effects of transitory shocks on commodity prices or supply chains play themselves out and focus on its maximum employment goal. But as inflation expectations become unanchored, those shocks are harder to ignore and the Fed needs to act more forcefully. So, we thought that it was important to track whether this was happening or not.

Waddell: Yep, I agree. The economy is made up of all sorts of actors making all sorts of decisions about how they spend, save, and invest. It's important to understand how economic conditions and policy shape the decisions that firms are making. If we don't understand how firms react, it'll make it much more difficult to make policy that best serves the economy.

This is partly why our Reserve Bank president [Tom Barkin] spends a lot of time trying to understand both what is currently happening with businesses in the region but also what they're expecting for the future. For inflation, particularly, understanding any turning point in the unanchored of expectations is critical. As we collect this kind of survey data, we'll continue to learn about how firms are making their decisions, and thus help set policy that promotes our mandate of both maximum employment and price stability.

Sablik: With that in mind, do you plan to keep collecting this data in your surveys?

Waddell: Absolutely. Of course, our surveys of businesses have been around for over 40 years and we'll continue to use them to better understand economic conditions in the region. We'll also continue to ask these quarterly questions on inflation expectations and their role in price setting for the foreseeable future. These questions will continue to help us better understand how firm price setting reacts in high- and low-inflation environments. This was important when inflation was high, and it's important as inflation comes back to the FOMC's 2 percent target.

Sablik: Felipe and Sonya, thank you so much for joining me today.

Waddell: Thank you, Tim.

Schwartzman: Thank you.