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Firm Price-Setting Behavior Amid Elevated Price Growth: Evidence From Our Surveys

Regional Matters
March 28, 2023

Every month, the Richmond Fed surveys firms across the Fifth District to understand how economic and business conditions are changing. As a part of this survey, we ask firms to report the 12-month percentage change in the prices they receive from customers for their goods or services. Additionally, we ask firms to provide their expectations for how prices will change over the next 12 months.

As inflation has picked up in the U.S. economy, we have paid particular attention to the price measures from our surveys. Not surprisingly, firms in our district have experienced higher price growth since 2021. Additionally, by comparing forecasted price growth to realized price growth, we find that firms were increasingly surprised by the intensity of price growth. As forecasts became less accurate and uncertainty around price growth rose, firms began to adjust their prices more frequently.

What Can Economic Theory Tell Us About Firm Price-Setting Behavior?

Firms set their prices based on several factors, including their input prices and what competitors are charging. While prices for some commodities (e.g., oil, wheat, gold) adjust to market information nearly instantaneously, many goods and services are subject to fixed costs that prevent prices from changing overnight (e.g., restaurants printing new menus), resulting in price stickiness.

Economists have long used contracts to model firms' pricing behavior to illustrate how they may be inhibited from adjusting their prices in the short run. A 1980 article by John Taylor proposes that firms are prevented from adjusting their prices until a pre-specified contract period expires. However, a long line of research, including work by Michael Dotsey, Robert King and Alexander Wolman examines how the state of the economy can impact the frequency of firms' price adjustments when there are fixed costs to adjusting; in theory, both higher inflation and greater volatility lead to more frequent price adjustments. Correspondingly, Robert Rich and Joseph Tracy find that as average inflation and inflation uncertainty increases, firms are more willing to incur fixed costs associated with price changes by shortening contract lengths and adjusting prices more frequently. Our survey results provide a window through which to observe how the recent inflationary environment may have influenced the pricing behavior of Fifth District firms.

Price Growth in Fifth District Slowing but Still Above Pre-COVID-19 Levels

Before the COVID-19 pandemic, both the realized annual growth rate of prices firms received from customers and the expected growth rate were relatively stable, hovering around 2 percent. In 2021, Fifth District firms started to experience increased price growth. The realized average growth rate of prices received peaked at 10 percent for manufacturers in mid-2022 and 7 percent for service-sector firms in late 2022. Since then, manufacturing price growth has slowed while service-sector growth rates have remained relatively flat. As the year-over-year growth rate of prices received spiked starting in 2021, so did expectations about the prices they will receive from customers over the next 12 months. However, the expected price growth never reached realized price growth.

Firms — Uncertain About Future Prices — Are Revisiting Pricing Decisions More Regularly

Fifth District firms have confronted higher uncertainty in price growth over the last few years. Our survey results indicate that firms' expectations about future price growth became more dispersed starting in 2020, as indicated by the increase in the standard deviation of the expected growth in prices received, especially among service-sector firms. Additionally, the mean forecast error — the difference between the realized and expected growth rate of prices for a given year — noticeably increased in 2021. This was especially true for manufacturers, as their average forecast error reached 10 percentage points compared to 3 percentage points for service-sector firms. Perhaps the increase in forecast error is not surprising, since in the past two years, firms have experienced unexpected supply chain disruptions, challenges finding workers with the right skills and higher wages.

As economic theory suggests, higher and more volatile price growth might encourage firms to adjust their prices more often. According to a set of special questions that we asked in March, almost seven in 10 firms adjusted their prices annually or even less frequently than annually before the COVID-19 pandemic. However, in the past two years, firms have been adjusting their prices more regularly.

Firms Anticipate Price Growth Above Pre-COVID-19 Norms

Expected own-firm price growth has slowed for service-sector firms and manufacturers since mid-2022. However, most firms (59 percent) still anticipate growth in the prices they charge customers in the first half of 2023 to be higher than pre-pandemic. It varies by industry: More service-sector firms than manufacturing firms expect price growth in 2023 to be above pre-COVID-19 price growth.

Closing Thoughts

Fifth District firms have experienced faster price growth since 2021. Most firms in our survey did not forecast the strong price growth that they ended up experiencing. Additionally, increased uncertainty coincided with firms adjusting their own prices more frequently than before the pandemic. Although firms still expected price growth to be above pre-COVID-19 norms in the first half of 2023, their realized price growth is now closer to expectations. In addition to lowered price growth expectations, the improved forecast accuracy bodes well for firm planning in 2023 and beyond.

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Joseph Mengedoth (804) 762-2285