The modest decline in US inflation during the Great Recession surprised many economists, sparking what’s been coined the missing deflation puzzle. With GDP contracting so strongly and unemployment hitting 10 percent, inflation should have dropped more severely, at least according to traditional Phillips curve models.
But the downturn’s deflation wasn’t necessarily missing. Rather, consumers changed their buying habits in a way not captured in the Consumer Price Index data, argues Omiros Kouvavas, University of Warwick PhD candidate.
The issue is due to what the literature calls trading down. When times are tough, consumers have the option either to buy less of a product or to buy cheaper versions of it. Kouvavas posits that during economic downturns such as the Great Recession, consumers choose cheaper products, such as generic versus name-brand goods. The reverse, he finds, is true during times of expansion, when consumers choose more-expensive brands.
It was these changes in consumption behavior that partially account for the low deflation rates seen during the Great Recession, as well as the modest inflationary increases during the recovery. If, as his research suggests, the business cycle leads to trading up or down in quality, this can bias the measurement of observed aggregate inflation, Kouvavas argues.
He cautions that it is difficult to extrapolate his findings to the present. “The current inflation dynamics are driven by supply-side constraints, which will have an impact also on the ability of people to trade up or down,” he says. Thus, a pattern he sees in normal economic cycles might not apply to the most recent years.
During the Great Recession and the slow recovery that followed, US consumers switched to lower quality alternatives of various products.
To track US consumption choices, Kouvavas used NielsenIQ Retail Scanner Data housed at Chicago Booth’s Kilts Center for Marketing. The data cover 35,000 outlets, including drug and grocery stores that belong to more than 90 retail chains spanning 55 metropolitan statistical areas. Kouvavas examined both the prices and quantities of purchases for more than 2.6 million UPC codes from 2006 to 2017, which he says allowed him to measure the ratio of high- to low-quality goods consumers purchased before, during, and coming out of the recession.
He finds that across all 10 product categories—from dry groceries to health and beauty to alcoholic beverages—the ratio of high- to low-quality goods purchased dropped from 2009 to 2011, and then rose during the recovery. By 2015–17, the ratio was at its peak for all categories but one. “It follows the economic cycle,” Kouvavas says. “You see that in all categories. People respond.”
It isn’t just the quantity of goods that consumers buy but the quality that matters, an important factor that the CPI doesn’t fully capture, he argues. And because of this, measured inflation will tend to decrease less than expected during downturns and increase less than expected during upturns.
Why was the trading-down bias so significant during the Great Recession, more so than during previous downturns? The answer, Kouvavas says, lies on grocery-store shelves and in Amazon searches. There are more products available to us now than ever before, and more products across a variety of qualities make for a bigger bias. “This isn’t 100 percent accounted for in the CPI,” says Kouvavas. “If we miss this kind of action, you miss part of the reason inflation appears steadier.”
Omiros Kouvavas, “Trading Down and Inflation,” Working paper, September 2020.
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