How Expecting Inflation Un-Anchors Manufacturers’ Pricing Strategy

I still think that “anchored inflation expectations” is a term that is devilishly difficult to define and measure, and therefore shouldn’t be a part of monetary policy planning. By the time you know that inflation expectations have become un-anchored, it’s too late to anchor them again because (theoretically) behaviors change when the inflation regime is perceived to have moved from “low and stable” to “higher and more volatile.” Generally left undiscussed is how behaviors change in this transition; it always sounds like the notion is that sellers can’t change prices, unless buyers expect them to do so…or unless sellers expect that buyer expect them to do so.

Person Holding Blue and Clear Ballpoint Pen

Image Source: Pexels

But there are some deeper mechanics of pricing that, we can illustrate, can produce a state-shift in pricing policy when expectations are for prices to generally rise. To the extent this happens, it could support the idea that once the state-shift happens, it is not trivial to shift it back.

Let’s first examine a case where a manufacturer expects cost increases to be followed by cost decreases, and vice-versa. Consider two pricing strategies: in one, the manufacturer passes through 100% of the cost increases to its price, so that its profit remains stable. The chart below shows costs per unit varying in blue, the producer’s price to its customers in red, and the net profit in green at the bottom.

An alternative pricing strategy is to pass through only a portion of the cost changes. In the chart below, the manufacturer adjusts prices only 25% of the movement in costs, absorbing the rest into its margin.

The second strategy results in a more-volatile earnings stream, but averages over time to the same level of profits. More usefully, it means a much more stable price to the customer, which customers clearly prefer. In the real world, where costs change more chaotically than this idealized oscillation, such price-dampening behavior likely leads to steadier end-customer demand and, over time, this potentially means more unit sales and greater total profit.

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