Inflation and firms’ price-setting behaviour In the medium-to-long run, the average rate of inflation is determined by the rate of nominal expansion permitted by the monetary authority. But over shorter horizons, decisions taken by businesses – in particular, about wages and prices – affect quarter-to-quarter fluctuations in inflation and, more generally, how demand pressures feed through to inflation. Economic policymakers draw on a number of ways of thinking about those influences on inflation dynamics. There is no model that can, uniquely, capture the richness of the real world. But surprising though it may be to some, one of the ways in which we think about firms’ price-setting behaviour would be familiar to anyone running a business. Namely, that firms charge a mark up, or profit margin, over the marginal costs of their various inputs – labour, capital, raw and intermediate materials, etc – with both the mark up and costs varying according to current and prospective demand conditions. This is represented schematically, indeed crudely, in Diagram 1. The key feature is that when demand rises and firms utilise their capacity more fully and add to their labour force, their costs and prices tend to rise. That might involve old-fashioned ‘cost-push’ inflation, with firms raising prices to maintain margins in the face of increased (marginal) costs. Or firms might initially be able temporarily to raise margins, with labour and other costs later ‘catching up’. In either case, firms and wage bargainers will be influenced by what they think is going to happen to inflation in the future.
The internet, or e-commerce, also brings greater contestability, by making it a lot easier for businesses to check the prices of competing suppliers, and for consumers to compare prices across different retailers (Table 3). Over time, these forces would be expected to reduce firms’ margins – at least in sectors that were not previously especially competitive. So long as that process of adjustment was underway, inflation would tend to be lower than would otherwise be implied by any given set of demand conditions. In addition, if and when their margins became thinner, firms might become more aggressive in controlling costs in the face of fluctuating demand, which might weaken the pass through of demand shocks into inflation. The new monetary framework might reinforce some of those effects. Over recent years, more than a handful of business managers have commented that, when inflation was both high and highly variable, it used to be easier to implement – or ‘get away with’ – price increases. In a low inflation environment, it should be easier for business customers and consumers to distinguish relative price changes from increases in the general price level. That too should foster greater flexibility and efficiency in our economy; and is one of the contributions that low and stable inflation can potentially make to broader economic welfare. One striking example is the distribution sector. Anecdotally, competition in UK retailing has been intense. This seems to manifest itself in the aggregate data in two phases.