Thursday, August 30, 2018

Monetary policy in the age of Amazon

Short-term nominal wage-price rigidity or sticky prices are a feature of New Keynesian models. It is also the basis for the prevailing wisdom on monetary policy actions.

Faced with a negative supply shock and attendant demand-pull inflation pressures, central banks raise rates so as to slow down the economy and reduce demand. The central bank action is motivated by the sticky price belief. But what if prices are not sticky and are increasingly responsive to economic signals?

In a paper presented at the Jackson Hole Symposium, Alberto Cavallo studied pricing behaviours for large multi-channel retailers in the US over the past ten years and shows that, especially for supply shocks, "online competition increases both the frequency of price changes and the degree of uniform prices across locations". He writes,
The evidence... suggests that competition with online retailers has increased the frequency of price changes in US retail markets... I find that traditional retailers that sell online tend to have a high degree of uniform pricing, which closely resembles the behavior of Amazon. In the cross section, the more a good competes with Amazon, the higher the degree of uniform pricing.
In simple terms, online competition is making prices more flexible and uniform even in the offline markets. In fact, it is now well documented that not only online retailers even offline retailers are resorting to uniform pricing across their stores, and there is convergence not only across stores within the same retail chain but between retailers. 

These trends have have implications for monetary policy,
For monetary policy and those interested in inflation dynamics, the implication is that retail prices are becoming less “insulated” from these common nationwide shocks. Fuel prices, exchange-rate fluctuations, or any other force affecting costs that may enter the pricing algorithms used by these firms are more likely to have a faster and larger impact on retail prices that in the past... For monetary models and empirical work, my results suggest that the focus needs to move beyond traditional nominal rigidities: labor costs, limited information, and even “decision costs” (related to inattention and the limited capacity to process data) will tend to disappear as more retailers use algorithms to make pricing decisions... The gas-price pass-through rate is 22% in a single quarter, and it rises from 19% to 28% for goods that can be easily found on Amazon. The short-run exchange-rate pass-through is 32%, and rises from 26% to 44% when a good can found on Amazon.
Yuriy Gorodnichenko, as a discussant to the Cavallo paper, offers more specific suggestions,
First, monetary policy should be more aggressive in combatting recessions. Second, central banks should likely... care less about inflation and... put a higher weight on volatility of output as more flexible prices lead to smaller distortions in the allocation of resources. Third, holding everything else constant, inflation will likely become more volatile and cyclically sensitive, more dominated by transitory shocks, and potentially more difficult to control in the short run. Fourth, central banks will possibly need to redefine their targets and operations to respond to the evolving nature of price setting in the retail sector. Perhaps, central banks will need to develop new tools to make their policies more targeted.
Since prices are sticky, firms, being stuck with their chosen prices for some time, incorporate more information about future inflation into their pricing decisions. Also sticky prices react to more persistent shocks and is the main driver of cross-sectional price dispersion. The objective function of central banks, by relying on a price index that overweighs sticky prices, is therefore more reliably targeting inflation expectations. But, on the contrary, if prices become more flexible, and central banks target a price index with higher-frequency changes, it may end up destabilising the economy.

At a broader macroeconomic level, this is one more evidence in support of the globalisation of inflation argument. As price transmission increases, global shocks will have a much greater impact on  domestic prices than earlier.

Equally important, flexible and uniform prices reduces the space available (for different actors) to accommodate non-uniform shocks. Sellers would not be able to lower prices in an area in response to a negative demand shock (say, a natural disaster). This can, in turn, exacerbate and prolong downturns. 

Monetary policy aside, the impact of e-commerce firms may be even greater in developing countries where the level of market fragmentation is much greater to start with. In these markets, as their penetration increases, the impact of online retailers can be far-reaching. On the one hand, lower overheads and economies of scale will provide them with the competitive advantage to supply goods at cheaper rates. On the other hand, the easily available price information from their sites will bridge information asymmetry and could create conditions that deter differential pricing and price gouging. 

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