Endogenous firm planning horizons amplify inflation volatility
Federal Reserve researchers demonstrate that firms dynamically adjust how far ahead to plan when setting prices. Large economic shocks induce deeper forward planning, which heightens inflation sensitivity and endogenously drives inflation uncertainty.
Cognitive trade-offs in price setting
Federal Reserve researchers Christopher Gust, Edward Herbst, and David López-Salido develop a finite-horizon model where price-setting firms choose how far ahead to plan.
While evaluating future contingencies improves pricing decisions, doing so requires costly cognitive effort.
When aggregate demand or supply disturbances are large and persistent, future economic conditions become crucial, prompting firms to extend their planning horizons.
This state-dependent cognitive effort makes aggregate inflation significantly more sensitive to underlying economic shocks.
Consequently, conditional inflation volatility fluctuates over time even when the variance of exogenous shocks remains constant.
Matching four decades of forecast data
Calibrated to U.S. data, the model finds firms plan about four quarters ahead on average, with cognitive costs staying below 0.05 percent of steady-state profits.
The framework matches the positive correlation between forecast revisions and inflation uncertainty observed in Survey of Professional Forecasters data, showing a 0.44 correlation compared to 0.43 empirically.
While explaining roughly 14 percent of overall uncertainty variance, the mechanism correctly captures volatility spikes during the 1970s, the Great Financial Crisis, and the post-pandemic inflation surge.
A vital mechanism with clear boundaries
This research convincingly shows that behavioral friction alone can generate time-varying inflation risk without relying on exogenous shock volatility.
However, accounting for only 14 percent of observed uncertainty variation leaves the bulk of inflation risk unexplained.
Central bankers should nevertheless monitor shifts in corporate planning horizons when evaluating policy transmission.