Collaborative Research: Inflation Dynamics During the Financial Crisis

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From a macroeconomic perspective, one of the most puzzling aspects of the 2007-09 financialcrisis and the ensuing slow recovery is the relative stability of inflation. Despite a large and sharpcontraction in output in the second half of 2008 and the persistently high level of resource slackover the past several years, the U.S. experienced only a modest degree of disinflationarypressures-both at the wholesale and retail levels-behavior that is difficult to explain withcanonical models of aggregate inflation determination. This project studies the extent to whichthe massive tightening of financial conditions at the height of the crisis in the latter part of 2008may help explain why inflation did not fall as much as expected during the financial crisis and thesubsequent recovery. The underlying hypothesis posits that some firms may strategically set lowprices to attract customers, behavior implied by the "customer-markets theory," whichemphasizes 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 theircompetitors in order to attract new customers. In turn, this implies low current mark-ups andhence lower cash flows.However, in times of widespread financial distress-when external finance becomes prohibitivelycostly or even unavailable-financially vulnerable firms will sacrifice their customer base byraising prices to stabilize current revenues and bolster their liquidity positions. Thus in periods ofacute financial distress, inflation may actually rise despite a drop in economic activity and theemergence of a significant degree of resource underutilization. The possibility that inflation andoutput move in opposite directions in response to an adverse demand shock also challengesconventional thinking regarding the appropriate course of action for monetary policy duringfinancial crises.To examine this hypothesis empirically, the project merges firm-level financial data with thecorresponding firm-level inflation rates computed from the confidential price data collected bythe Bureau of Labor Statistics (BLS). Preliminary results indicate that financial factors had asignificant 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 implicationsof this mechanism for aggregate inflation dynamics have remained largely unexplored, and thisstudy provides some of the first systematic evidence on how financial conditions influence theprice-setting behavior of firms through the incentives to set prices in a manner that preserves theirliquidity and balance sheet capacity.To the extent that this channel is quantitatively important, the analysis in this project has a directbearing on gauging the likelihood of destructive large-scale disinflations during financial crises. Italso has important implications for the conduct of monetary policy by arguing that policy makersshould take into account the interaction between changes in the quality of the firms' balancesheets and their price-setting behavior when deciding on the future course of nominal interestrates. In addition to developing the matching algorithm that links BLS' researcher databases withoutside firm-level data sets, the project also provides a new measure of local bank credit-supplyconditions based on the GPS coordinates that may be used in conjunction with future BLSstudies, opening up a whole new set of research possibilities on the spatial interaction betweenfinancial conditions and firm behavior.