In their latest World Economic Outlook , IMF analysts pointed out that inflation "has become less responsive to cyclical conditions." This prompted Simon Wren-Lewis to consider valid explanations. At his Mainly Macro blog, he puts forward one that has to do with banks, risk, and sacrificing long term strategy because of short term fears: The story I want to tell involves firms’ pricing behaviour, and the role of more risk averse banks. Suppose a firm sees demand for its output fall. Its profits are lower, but it calculates that it can reduce that decline in profits by cutting its price, if that price cut increases demand. There are two risks involved in doing this. First, the price cut might raise demand by much less than expected, with the consequence that profits fall further still. Once the firm realises this it can always put prices back up again, but in the short run profits will decline. Second, it may take time for the price cut to feed through into higher demand: those buying competing products may not immediately realise that they should switch. So although profits might rise eventually, they could fall in the short run. So in both cases, there is a risk that profits in the short run might suffer as a result of the price cut. In normal times firms would be prepared to take those risks, either because the risks are symmetric (maybe demand will increase by more than expected), or because they represent an investment with a positive eventual payoff (as customers switch products). Critically, even if the short run might actually bring losses rather than profits, the firm’s bank will cover the losses because it is taking a long term view. However, since the financial crisis, the firm may have noticed that the behaviour of its bank has changed. It refused the business down the road any credit, even though by all accounts its difficulties were clearly temporary. Although the firm would like to cut prices in the expectation that this will eventually raise profits, if the price cutting idea does not work out and the bank plays tough that could mean bankruptcy. The idea is that the aftermath of the financial crisis, by raising the risk of bankruptcy associated with short term losses, has lead to greater price rigidity. In addition, there are two related effects that could actually lead to higher inflation in the short run. First, the firm does not like the fact that it can no longer depend on the bank to cover any short term losses. Who knows what might happen. So although a price increase might reduce profits if sustained (as customers gradually switch), in the short run profits will rise, and that allows the firm to pay off those debts which would otherwise keep its owners awake at night. This is the firm as a precautionary saver. Second, firms might be keeping prices low not because of existing competition, but because of the threat that a new start-up might emerge and steal some of its business. The one silver lining of the financial crisis for existing firms is that new start-ups are much less likely to get any money from the bank, so this diminished threat of new entry allows the firm to safely increase its profit margins. Read the full post here .
Filed under: interest rates, IMF, loans, banks, world economic outlook, inflation, macroeconmic policy, risk aversion, capital exchange, Mainly Macro, Simon Wren-Lewis, cyclical conditions