Thursday, May 27, 2010

Sticky prices

This post by Nick Rowe:

Returning from a long weekend's canoeing, I remembered one of the main reasons I am a sticky-price macroeconomist. I checked to see if the economy had imploded while I was not worrying about it. April CPI up 0.1% from March; CAD/USD down about 2%; CAD/EUR up about 2%; TSX down around 3%; S&P500 down around 6%; oil down around 3%, etc.

You get the picture. The exact numbers don't matter. The CPI moved less in one whole month than all the other numbers moved in my 4-day weekend. A whole order of magnitude less. The CPI is a boring number. Anybody can predict next month's CPI within a 1% range; nobody can predict next month's exchange rates, oil prices, or stock prices with that degree of accuracy.

But what does this tell us?

My long weekend was a time of big changes in demands and supplies of financial assets, and the prices of all those financial assets relative to each other changed a lot in 4 days. But nothing seemed to have changed when I took my Loonies to the local supermarket. And I bet nothing much changed when Europeans and Americans took their Euros and US dollars to their local supermarkets, buying bread and milk like I did, even though the Loonie, Euro, and US dollar had all changed relative to each other. (OK, gas prices were about 2% lower when I returned, but that might be because they always seem to go up at the beginning of a long weekend.)

We don't usually think of the CPI as an asset price, but it is. Or rather, its inverse is. The CPI is the price of a basket of goods in terms of money, so 1/CPI is the price of money in terms of goods. Money is a financial asset, so 1/CPI is the price of a financial asset. TSX/CPI is the price of another financial asset, the TSX basket of shares, in terms of goods. CAD/USD is the price of one money in terms of another money. 1/CPI is much more predictable, at a one month horizon, than TSX/CPI or CAD/USD. About one order of magnitude more predictable.

This fact tells me that most of the prices that make up the CPI are sticky. I can't make sense of it any other way. I don't like the assumption of sticky prices; I hate that assumption, because it is assuming something we ought to be explaining. But until I hear a satisfactory explanation for why the monthly CPI is so predictable, I don't have a better alternative.

Why are prices sticky? Is it because consumers expect predictability?
1. Twenty years ago I paid $30 for a pair of sneakers. Truthfully, it would be hard to persuade me to pay any more today. Fortunately, for technological progress and offshoring, sneaker prices have been able to stay around the $30 range. Unfortunately, they're not quite the same quality sneakers. Same with shirts - I'd be more than a little upset to pay more than $20 for a shirt.

2. 5 years ago we spent the weekend at the Hyatt Chesapeake Resort. We probably paid about $250 per night for the room for a stay in October. These days we go during the off season where rooms can be had for $99 per night. Even today I would be aghast at paying more than $250 per night. Prices in fact have gone up to $350 per night during the peak season (late spring - summer) but at in late fall can still be had for $250.

Or perhaps it's not expectations that are sticky and maybe it's just that I'm cheap.

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