Shifts in Australian Price-setting Behaviour Around Large Shocks

The sharp rise in inflation during the COVID-19 pandemic has renewed interest in how firms adjust prices in response to large economic shocks and what this means for modelling inflation dynamics and setting monetary policy. Using a large dataset of web-scraped Australian retail prices, we document a decline in price rigidity in 2022 and 2023, coinciding with a period of strong goods price inflation in Australia. Firms became more willing to adjust prices at this time, leading to more frequent price changes. We incorporate these microdata-based estimates of price-setting behaviour into the RBA’s DSGE model to assess their macroeconomic implications. We find that failing to account for declining price rigidity during the COIVD era could have led forecasters to underpredict inflation by up to 1.5 percentage points, even if they knew exactly which shocks were hitting the economy at the time . Moreover, lower price rigidity significantly steepened the Phillips curve, reducing the policy trade-off between inflation and output and meaning that it was optimal to raise rates more aggressively by up to around 50 basis points, compared to the case where rigidity did not change.  Our findings highlight the importance of recognising shifts in price-setting behaviour when interpreting inflation outcomes and designing monetary policy.