Downward price and wage rigidities.
The case of Romania.
Cezar Boţel
Monetary policy and macroeconomic modeling department
National Bank of Romania
Bucharest,
May 18th 2010
Summary
1. Inflation developments and major shocks, 2005-2009.
2. Time series estimates of inflation persistence.
3. Survey-based assessment of price rigidities.
4. Case study: inflation behavior during the global crisis.
5. Conclusions.
Definition of concepts
CORE1 prices
=
CPI basket
=
+
CORE2 prices
[= CORE3 prices
+ alcohol and tobacco prices]
+
Volatile food prices
+
Fuel prices
Administered prices
1. Inflation developments and major shocks, 2005-2009.
General overview.
33
25
yoy
28
20
23
15
18
10
13
5
8
0
3
-2
Jan-05
-5
Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08
Jan-09 Jul-09 Jan-10
-10
-7
-12
-17
Headline (CPI) inflation
CORE2 inflation
Administered price inflation
Vegetables, fruit and eggs inflation
Fuel inflation
Annual EURRON dynamics (rhs)
-15
-20
1. Inflation developments and major shocks, 2005-2009.
Shocks hitting the economy.
• Adverse shocks to inflation:
¾ volatile food prices (2005, 2007);
¾ exchange rate (2007, 2008, 2009);
¾ fuel prices (2007-2008, 2009-2010);
¾ highly pro-cyclical fiscal policy (2008);
¾ ahead of schedule adjustment in excise duties on tobacco (2005, 2009);
¾ administered prices (with dynamics above that of CPI inflation since - at least 2000).
• Favorable shocks to inflation:
¾ volatile food prices (2006);
¾ exchange rate (2007, 2010);
¾ contraction of aggregate demand (2009-2010).
2. Time series estimates of inflation persistence.
Methodology.
• the data-generating
components:
process
of
inflation
broken
down
into
distinct
¾ intrinsic inflation persistence in response to shocks hitting inflation directly
(e.g. peculiarities of price and wage-setting mechanisms).
¾extrinsic inflation persistence - persistence in the drivers of inflation;
• univariate approach using CORE3 (“free prices”) inflation;
• time-varying estimates of the relevant coefficients;
• data sample: 1999M09-2010M02.
2. Time series estimates of inflation persistence.
Results (a).
Core3 inflation, mom
0.85
Mean
2.00
2010M2
2009M10
2009M6
k
2009M2
0.164
2008M10
2008M6
2008M2
2007M10
2007M6
2007M2
2006M10
2006M6
2006M2
2005M10
2005M6
2005M2
2004M10
2004M6
2004M2
2003M10
2003M6
2003M2
2002M10
2002M6
2010M2
2009M10
2009M6
2009M2
2008M10
2008M6
2008M2
2007M10
2007M6
2007M2
2006M10
2006M6
2006M2
2005M10
2005M6
2005M2
2004M10
2004M6
2004M2
2003M10
2003M6
2003M2
2002M10
2002M6
2002M2
2001M10
2001M6
• time-varying AR coefficients,
specified as random walks.
0.158
2002M2
2001M10
j=1
0.160
2001M6
π t =μ t +∑ α j ⋅ π t-j +ε t
0.162
0.00
Standard deviation of the error term
0.50
2010M2
2009M10
2009M6
2009M2
2008M10
2008M6
2008M2
2007M10
2007M6
2007M2
2006M10
2006M6
2006M2
2005M10
2005M6
2005M2
2004M10
2004M6
2004M2
2003M10
2003M6
2003M2
2002M10
2002M6
2002M2
2001M10
2001M6
Confidence interval
0.166
1.50
0.75
1.00
CORE3 inflation persistence
Confidence interval
0.70
2.50
0.90
0.80
0.65
0.168
2. Time series estimates of inflation persistence.
Results (b).
• by employing the same methodology, but using CORE2 inflation as a benchmark,
the results exhibit some degree of noise, which is chiefly evident in the dynamics
of the inferred standard deviation of the error term…
1
0.9
Standard deviation of the error term
0.8
Confidence interval
0.7
0.6
0.5
0.4
0.3
0.2
…this is due to the excise duties on
tobacco, the adjustment of which is
subject to administered (government)
decisions.
%
14
0.1
12
0
Contribution of excise duties on
tobacco to annual CORE2 inflation
2010M2
2009M10
2009M6
2009M2
2008M10
2008M6
2008M2
2007M10
2007M6
2007M2
2006M10
2006M6
2006M2
2005M10
2005M6
2005M2
2004M10
2004M6
2004M2
2003M10
2003M6
2003M2
2002M10
2002M6
2002M2
2001M10
2001M6
CORE2 inflation rate (yoy)
10
8
6
4
2
0
2010M1
2009M1
2009M7
2009M4
2009M1
2008M1
2008M7
2008M4
2008M1
2007M1
2007M7
2007M4
2007M1
2006M1
2006M7
2006M4
2006M1
2005M1
2005M7
2005M4
2005M1
2004M1
2004M7
2004M4
2004M1
2003M1
2003M7
2003M4
2003M1
2. Time series estimates of inflation persistence.
Conclusions.
• the estimated mean of CORE3 inflation is by and large downward trending,
mimicking to a certain extent the permanent shifts in NBR’s inflation target
(explicit targets since 2005 - IT regime);
• increase of CORE3 intrinsic persistence since 2001, followed by a gradual
reduction (starting with 2006) and an opposite, increasing, trend in the
aftermath of the numerous inflation shocks hitting the economy since mid-2007;
• the standard deviation of the error term seems to point out to significant
extrinsic persistence;
• more precise identification is prevented by the reduced form estimation;
complementary analyses needed to identify specific sources of high persistence.
3. Survey based assessment of price rigidities.
Methodology.
• similar in scope with the studies of the Inflation Persistence Network (IPN)
of the ECB;
• carried out throughout 2006, but respondents were instructed to refer to
2005 as the reference year;
• representative sample based on firms with more than 10 employees, postweighted results reported;
• broad coverage (38 NACE sectors grouped into six main categories:
agriculture and related activities, manufacturing, energy, constructions, trade
and transport/communications);
• relatively low answer rate (20% out of a sample of 2000 firms, compared
with approximately 45% for the IPN studies).
Source: Copaciu et al (2010).
3. Survey based assessment of price rigidities.
Price setting models in the Romanian economy.
• role of the market structure: around 63% of the firms in the sample prefer
either mark-up pricing (43% of these firms) or adopting the market price
(50%). Mark-up pricing is primarily preferred by large firms;
• state-dependent pricing (43% of the respondents) predominate over timedependent pricing (15%), suggesting high sensitivity of prices to both
common and idiosyncratic shocks; preference for state dependent pricing
decreases with the size of the firms, while opposite is true for time and mixed
strategies;
• prices of competitors: ranks 3rd in the case of price increases and 1st in the
case of price decreases; competitors’ prices ranked as more important by
small and medium firms; results indicative of a potential asymmetric reaction
to favorable vs. unfavorable transitory shocks.
3. Survey based assessment of price rigidities.
Factors affecting price setting.
• Asymmetric response to supply and demand-related shocks:
• Supply-side factors are more relevant for price increases and less so for
price decreases, while the reverse is true about demand side factors; might be
related to the importance of contracts (either implicit, as in Rotemberg, 2005,
or explicit) and the prevalence of long term relationships with clients;
• Asymmetric response to positive vs. negative shocks:
¾ Larger size and higher frequency for price increases, as compared to price
decreases;
• Duration of price quotation – around five months for firms following a time-dependent
or mixed strategy;
• Regulated prices are modified less often than market prices, but when they are, they
tend to come in relatively large shocks;
• Wages are stickier than prices (only one wage change per year);
• No particular month for price changes, while January is preferred for wage changes.
4. Inflation behavior during the global crisis.
10
global financial crisis
8
6
4
2
0
2005Q1
-2
-4
-6
2005Q4
2006Q3
2007Q2
Annual CORE2 inflation
Annual average GDP gap
Quarterly GDP gap
2008Q1
2008Q4
2009Q3
• output-gap displayed larger
fluctuations and switched to
negative values following the
onset of the global crisis,
implying lower extrinsic
inflation persistence coming
from aggregate demand
pressures;
• however, other sources of
intrinsic or extrinsic persistence
proved to be highly relevant;
• Caveat: judgements about the potential of the economy and the degree of economic
slack are uncertain in real time; particularly during the current crisis, disentangling how
much of the abrupt slowdown in activity is due to structural factors (lowering the
potential GDP) is difficult.
N.B.: the graph illustrates the revised output gap.
4. Inflation behavior during the global crisis.
The motivation for potential output revision (a)
I. Effects of the financial crisis on the potential output
•
•
In the medium run, the output level is significantly below what would have
been obtained in the absence of the crisis;
In the long run, GDP growth rate returns to values comparable to those
achieved previous the crisis:
–
–
•
In the short run, the potential output fall is caused by total factor productivity;
In the medium run the negative development is caused by the persistence of low
capital stock and low employment.
The persistence and magnitude of the output losses from financial crisis
implies lower levels of potential GDP and lower growth rates for a long
period of time, as compared to those that would have resulted without the
crisis*.
*Source: IMF, World Economic Outlook, October 2009, chapter 4
4. Inflation behavior during the global crisis.
The motivation for potential output revision (b).
II. NIS data revision for GDP and components in March 2010
•
Between the February 2010 and the May 2010 NBR-Inflation Reports, NIS
has revised substantially the seasonally adjusted series for GDP and its
components, particularly for the 2008-2009 period.
–
The resulting differences are in magnitude and algebraic sign.
•
According to the new data, the cumulated value of gross fix capital
formation is inferior to the cumulated value for the old data set.
Consistently, a lower GFCF level implies a lower capital stock, which
results in lower values for potential output.
•
Compared to the previous round, the potential GDP level for the 20082009 period has been revised downward.
–
The values for the output gap are higher (i.e. larger positive gaps for 2008Q32008Q4 and smaller negative gaps for 2009Q1-2009Q4) when using the March
2010 data set, as compared to the old data set.
4. Inflation behavior during the global crisis.
Role of uncertainty (a).
• uncertainty level proxied by the estimated conditional volatility of CORE2 inflation in a
symmetric GARCH-M model.
0.18
Conditional variance of
qoq CORE2 inflation
0.15
0.13
0.10
0.08
0.05
0.03
2009M09
2009M01
2008M05
2007M09
2007M01
2006M05
2005M09
2005M01
2004M05
2003M09
2003M01
0.00
4. Inflation behavior during the global crisis.
Role of uncertainty (b).
• Estimation results:
• the main triggers of inflation uncertainty are the changes in inflation;
• the level of CORE2 inflation (be it high or low) does not appear to be
statistically significant;
• the existence of a statistically significant, though weak, non-linear
relationship between inflation uncertainty and inflation.
4. Inflation behavior during the global crisis.
Role of uncertainty (c).
• the investigation of potential asymmetries in the relationship between
inflation and inflation uncertainty can shed some more light on the pricing
decisions of firms;
• Threshold-GARCH (TGARCH) model;
• estimation (on the 2000M01-2009M12 sample) suggest an asymmetric
relationship: unfavorable shocks that affect inflation result in higher future
inflation uncertainty, whereas similar in magnitude, but negative shocks, have
as a result a lower uncertainty;
• this conclusion corroborates the results of the survey indicating stronger
reaction of firms to positive versus negative shocks.
4. Inflation behavior during the global crisis.
Role of uncertainty (d).
• the Friedman-Ball hypothesis regarding the correlation between inflation
and inflation uncertainty is confirmed within a symmetric GARCH-M setup:
a rise in inflation raises future inflation uncertainty;
¾suggests persistently high inflation uncertainty in the aftermath of
recurrent adverse shocks to CORE2 inflation;
• testing also validates the Cukierman-Meltzer hypothesis: inflation
uncertainty is one of the drivers of actual inflation;
¾implies higher inflation uncertainty (e.g. distinguishing permanent
from transitory shocks) today may lead to expectations of higher rate
of inflation in future periods;
• testing simultaneously both hypotheses confirms a bi-directional
influence between inflation uncertainty and CORE2 inflation – potential
source of vicious cycle in the presence of frequent adverse shocks.
4. Inflation behavior during the global crisis.
Role of inflation expectations.
• possibly the most persistent driver of CORE2 inflation:
¾ inflation expectations of economic agents are shaped by the dynamics of the
entire CPI basket, thus being sensitive to a considerably larger pool of
unfavorable shocks;
¾ high sensitivity of inflation expectations to supply-side shocks:
¾ due to relatively short track record of low inflation and monetary policy
under IT;
¾ amplified by the strength of some of the shocks hitting the economy
following the onset of the global crisis (e.g. the depreciation of the domestic
currency appears to have had a lasting impact on inflation expectations).
4. Inflation behavior during the global crisis.
Inflation expectations and the role of supply-side shocks.
• prevalence of supply-side shocks in driving the dynamics of CORE2 inflation; the
16
14
12
10
8
6
4
2
Gap of CPI to CORE2 yoy - 6 months leading
CORE2 - NTF
CORE2 inflation yoy
Lead of 5-6 months of CPI to CORE2 gap measure to
CORE2 inflation
gap of CPI to CORE2 inflation (i.e. volatile food, fuel and administered prices) is used as proxy for
supply-side shocks to inflation.
Ja
n0
Ju 4
n0
N 4
ov
-0
A 4
pr
Se 05
p0
Fe 5
b06
Ju
lD 06
ec
-0
M 6
ay
-0
O 7
ct
-0
M 7
ar
-0
A 8
ug
-0
Ja 8
n0
Ju 9
nN 09
ov
-0
A 9
pr
-1
0
0
• the adverse supply-shocks (green bars)
create the expectations of future higher
CORE2 prices – firms are expected to
compensate for the increase in production
costs aiming to defend the profit margin;
• moreover, during the crisis, companies faced
with tight credit conditions were probably
more strongly focused on the dynamics of
cash-flow, thereby preferring not to reduce
prices if that might have resulted in a revenue
loss.
4. Inflation behavior during the global crisis.
Role of the labor market (a).
40
Total
Industry
Constructions
Services
Output gap (rh)
yoy
30
yoy
6.5
4.5
20
2.5
10
0.5
0
Q1
2003
Q4
2003
Q3
2004
Q2
2005
Q1
2006
Q4
2006
Q3
2007
Q2
2008
Q1
2009
Q4
2009
-10
Annual dynamics of nominal ULC
-20
N.B. the dynamics of the ULC was not identical across
all the sectors of the economy and not even within each
sector.
-1.5
-3.5
-5.5
• inflation of non-food items in CORE2
inflation displayed a high degree of
stickiness (unlike the non-food items)
during the crisis, despite the contraction
in consumer demand;
• domestic producers’ reluctance to cut
prices may be partially attributed to the
lagged and still incomplete adjustment of
(nominal) unit labor costs to the
contraction in the volume of activity;
• the main driver of the still positive
dynamics of ULC is the sticky adjustment
of the gross wages, whereas employment
declined with varying intensities in
almost all sectors.
4. Inflation behavior during the global crisis.
Role of the labor market (b).
yoy
yoy
Economy
30
30
Employment
Gross wages
Gross wages
20
Nom ULC
20
Employment
Value added/GDP
Value added/GDP
25
Industry
Nom ULC
10
15
10
0
5
0
-10
-5
-20
-10
-30
-15
Q1
Q4
Q3
2003 2003 2004
Q2
Q1
2005 2006
Q4
Q3
2006 2007
Q2
Q1
Q4
2008 2009 2009
Q1
Q4
Q3
Q2
Q1
Q4
Q3
Q2
Q1
Q4
2003 2003 2004 2005 2006 2006 2007 2008 2009 2009
Decomposition of y-o-y growth of nominal unit labor costs
(N.B.: GVA has a contribution opposite its actual dynamics, e.g. a negative annual dynamics contributes
positively to nominal ULC).
4. Inflation behavior during the global crisis.
Role of the labor market (c).
• the government’s compensation of
employees increased continuously since
2005, outpacing (in nominal terms) the
dynamics of domestic economic activity,
which led to an ever increasing share of
this component in GDP;
• the annual growth rate of gross real
wages in the budgetary sector surpassed to
a great extent the dynamics in other
sectors of the economy…
• … contributing to the structural rigidities
of the labor market (directly as well as
through the demonstration effect on
private sector wages) and therefore to the
persistency of CORE2 inflation.
%
Annual dynamics of gross real wages
24
21
18
15
12
9
Economy
6
Private sector
Budgetary sector
3
0
-3
Feb05
Jul05
Dec- May- Oct- Mar- Aug- Jan- Jun- Nov- Apr- Sep05
06
06
07
07
08
08
08
09
09
• however, a tightening of the wage policy for
public sector employees was evident during 2009
and the beginning of 2010, being expected to
affect favorably the future dynamics of core
inflation.
4. Inflation behavior during the global crisis.
Role of the labor market (d).
• survey-based measures of wage persistence show that approximately 58% of the
firms change their employees’ wages once a year (14% less than once a year);
consistently with this finding, the slow responsiveness of wages in the first part of
2009 was explained by the inertial component induced by the provisions of the
existing collective labor contracts (as well as by an economy-wide increase in minimum
gross wage);
• whereas the results of the survey indicated that firms change wages taking into
account the dynamics of productivity, taxes, demand and inflation (in that
particular order), the recent downturn witnessed the decoupling, at an aggregate
level, of wage adjustments from the dynamics of demand, with particular intensity
in the public sector (however, this trend was amended during the last months).
5. Conclusions (a)
• Over 2005-2009, inflation persistence remained high, despite the switch to
inflation targeting, increased transparency and time consistency of monetary
policy and even the severe aggregate demand contraction triggered by the global
crisis;
• Main reasons:
• on the background of structural rigidities (asymmetries in firms’ pricesetting behavior & highly inertial wage adjustments, particularly in the public
sector), …
• … high frequency of unfavorable supply shocks throughout the period …
• … maintained persistently high inflation uncertainty, …
• … hindering the anchoring of inflation expectations to central bank’s
inflation targets.
5. Conclusions (b)
•
This causal process was strongly fuelled by the cluster of adverse supply
shocks between mid-2007 and mid-2008, on top of still increasing excess
demand;
•
Some recent trends (significant adjustments in public sector wages and in unit
labor costs across economic sectors, a substantially negative output gap) are
hinting to possibly decreasing inflation persistence ahead (provided no
additional series of unfavorable shocks hit the economy at least in the short-tomedium-run);
•
However, a firm and faster implementation of structural reforms,
particularly in the public sector, is critical for removing the rigidities that
induce high intrinsic inflation persistence and for minimizing economic
costs attached to the attainment of inflation targets in the medium run.