Collaborative Research: Inflation Dynamics During the Financial Crisis

Brandeis University, Waltham MA

Investigators

Abstract

From a macroeconomic perspective, one of the most puzzling aspects of the 2007-09 financial crisis and the ensuing slow recovery is the relative stability of inflation. Despite a large and sharp contraction in output in the second half of 2008 and the persistently high level of resource slack over the past several years, the U.S. experienced only a modest degree of disinflationary pressures-both at the wholesale and retail levels-behavior that is difficult to explain with canonical models of aggregate inflation determination. This project studies the extent to which the massive tightening of financial conditions at the height of the crisis in the latter part of 2008 may help explain why inflation did not fall as much as expected during the financial crisis and the subsequent recovery. The underlying hypothesis posits that some firms may strategically set low prices to attract customers, behavior implied by the "customer-markets theory," which emphasizes the idea that price setting is a form of investment that builds the future customer base. According to this theory, firms will in normal times maintain low prices relative to their competitors in order to attract new customers. In turn, this implies low current mark-ups and hence lower cash flows. However, in times of widespread financial distress-when external finance becomes prohibitively costly or even unavailable-financially vulnerable firms will sacrifice their customer base by raising prices to stabilize current revenues and bolster their liquidity positions. Thus in periods of acute financial distress, inflation may actually rise despite a drop in economic activity and the emergence of a significant degree of resource underutilization. The possibility that inflation and output move in opposite directions in response to an adverse demand shock also challenges conventional thinking regarding the appropriate course of action for monetary policy during financial crises. To examine this hypothesis empirically, the project merges firm-level financial data with the corresponding firm-level inflation rates computed from the confidential price data collected by the Bureau of Labor Statistics (BLS). Preliminary results indicate that financial factors had a significant effect on inflation dynamics during the 2007-09 crisis. Consistent with the hypothesis, financially "weak" firms raised prices in the latter part of 2008, whereas their financially "strong" counterparts lowered prices in response to a drop in aggregate demand. To date, the implications of this mechanism for aggregate inflation dynamics have remained largely unexplored, and this study provides some of the first systematic evidence on how financial conditions influence the price-setting behavior of firms through the incentives to set prices in a manner that preserves their liquidity and balance sheet capacity. To the extent that this channel is quantitatively important, the analysis in this project has a direct bearing on gauging the likelihood of destructive large-scale disinflations during financial crises. It also has important implications for the conduct of monetary policy by arguing that policy makers should take into account the interaction between changes in the quality of the firms' balance sheets and their price-setting behavior when deciding on the future course of nominal interest rates. In addition to developing the matching algorithm that links BLS' researcher databases with outside firm-level data sets, the project also provides a new measure of local bank credit-supply conditions based on the GPS coordinates that may be used in conjunction with future BLS studies, opening up a whole new set of research possibilities on the spatial interaction between financial conditions and firm behavior.