The economists Adam Smith and Milton Friedman both argued that prices are largely flexible, moving so quickly that the economy is bound to balance day-to-day volatility on its own long before government intervention — such as Fed actions on monetary policy — can. But John Maynard Keynes argued that prices move slowly and that monetary policy does have a key role to play in stabilizing the economy by stimulating or slowing growth.
The debate has become more nuanced over the last 10 years as economists have learned in greater detail how prices move and found that, in a sense, everyone is right. Aggregate prices — the averages for all prices in the economy as a whole — are indeed sticky. But in each sector, prices can move quickly and vary greatly depending on the kinds of shocks affecting a particular sector at any give time.
Professor Marc Giannoni worked with Jean Boivin of HEC Montreal and Ilian Mihov of INSEAD to reconcile the apparent contradiction that prices are both sticky and flexible. Does monetary policy simultaneously affect a large number of sectors? Or do sector-specific prices respond slowly when the Fed changes interest rates even though they respond very rapidly to sector-specific shocks?
While many sectors experience idiosyncratic shocks that create a lot of volatility in the sector, that volatility might not be reflected in overall prices because it gets offset by volatility in other sectors. “Prices can be extremely volatile in each individual sector,” Giannoni explains, “but on average prices remain very stable.”
If changes the Fed makes to interest rates have the same impact on prices that sector-specific shocks have, that implies that Fed actions would have a big impact on prices but not a lot of impact on economic activity, so it would not able to stimulate growth during a recession — or to slow overheated expansion in an upturn in an effort to control inflation.
The researchers looked at a broad range of key economic indicators between 1976 and 2005, including consumer and producer price indices, industrial output, interest rates and employment figures across sectors. Rather than focus only on aggregate prices, the researchers looked at the characteristics of prices that made them so sensitive — were prices changing in response to macro disturbances, including shifts in monetary policy, or something else?
By developing a statistical framework that distinguished sector-specific changes in prices from price changes in the aggregate, the researchers were able to see how different sectors moved in relation to macro shocks or sector-specific shocks.
The framework was built on the assumption that prices are driven by two sets of components: a set of macroeconomic components such as the effects of policy, aggregate demand shocks — reflecting, for instance, an increased willingness of consumers to purchase products — supply shocks, or oil price shocks, and a set of components that reflect variable conditions unique to a sector. For example, the weather might drive the price of vegetables but not of watches.
The researchers found that individual sector disturbances tend to be large and do have rapid effects on prices. For example, vegetable prices frequently fall or drop from day to day by as much as 20 percent depending on conditions in the agricultural sector.
But prices also respond to macroeconomic disturbances in a very different way: the researchers found that it’s only after several months that monetary policy starts affecting prices in most sectors.
The upshot is that monetary policy does have a key role to play in moderating the economy. “Since most sectoral prices don’t respond immediately to monetary policy actions,” says Giannoni, “monetary policy can affect economic activity in those sectors for a long period of time.”
Marc Gianonni is the Roderick H. Cushman Associate Professor of Business in the Finance and Economics Division at Columbia Business School.
Marc Giannoni was a Columbia Business School faculty member from 2002 to 2016.