Relative Services Price Dispersion, Trend Inflation and Inflation Volatility

Abstract

This chapter looks at the relationship between relative services price dispersion and the various aspects of inflation dynamics. The weight of services within the consumer price basket is slightly more than 50 per cent and a majority of the components of services prices display persistent trends which are normally well above the inflation target band. The electricity price increases in recent years is also seen as a key contributor to the degree of persistence and the trajectory of overall inflation. Evidence shows that there is unidirectional causality from inflation to relative services price dispersion. The turning point and threshold at which relative services price dispersion is minimised has systematically declined from high levels in the pre-inflation targeting period to within the inflation target band.

Evidence indicates that relative services price dispersion is driven by trend (expected) inflation supporting the menu costs theory. Thus, firm-specific menu costs lead to staggered price setting, thereby distorting the relative prices and inefficiently increasing relative price dispersion (RPD) of services prices. There is lack of evidence that indicates inflation volatility is a big driver of relative services price dispersion. In addition, evidence shows the direct effects occur of electricity prices on the price dispersion, the indirect effects via trend inflation and the inflation volatility channels. The policy implication is that monetary policy can affect relative services price dispersion by lowering trend or expected inflation to within the target range. Policy initiatives that reduce unexpected inflation will minimise the distortionary effects of high realised inflation in allocating resources and welfare.