Time-varying Price Flexibility and Inflation Dynamics

About the seminar

Title: Time-varying Price Flexibility and Inflation Dynamics

Authors: Ivan Petrella (University of Warwick & CEPR), Emiliano Santoro (University of Copenhagen), and Lasse de la Porte Simonsen (Birkbeck College)

Abstract: Using microdata underlying the UK consumer price index, we examine how time variation in the capacity of nominal demand to stimulate price adjustment--- broadly defined as price flexibility---shapes inflation dynamics. Price flexibility maps into a distinct non-linearity of the rate of inflation, whose half-life is twice as large in periods of relatively low flexibility. Such non-linearity naturally arises in environments characterized by state-dependent price setting, of which we find ample evidence in the data. Yet, this fact is often neglected in the practice of central banking. Indeed, we illustrate that a sizeable fraction of professional forecasters' in inflation prediction error is explained by time variation in price flexibility, especially at medium-term forecast horizons. Overlooking these facts may severely bias our understanding of price setting and in inflation dynamics.

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