We live in a world where Inflationary expectations can have a significant influence on the outcome. As inflation rises to levels not seen since the 1980s, central bankers are wary about driving inflation. If they warn of the possibility of inflation reaching levels last seen in the 1970s, will they do more damage than good?
Central banks, like Australia’s Reserve Bank, know the peril that inflation psychology brings. Expectations of high inflation are self-fulfilling prophecies driven by inflation psychology.
In its 2022 annual economic report, the Bank of International Settlements warned that the world had reached the tipping point. Inflationary psychology is entrenched. According to their statement, this is a significant paradigm shift.
Warnings such as these are known as “open mouth operations”. Central bankers use them as policy tools. They hope that their pronouncements will get through to the populace, convincing them to curb spending. If spending continues at the same rate, bankers must continue to raise interest rates with all the pain that brings.
Emotions drive inflationary psychology, so people often don’t respond to rational advice.
Global inflation is real. It has its origins in supply shortages caused by COVID lockdowns and the subsequent invasion of Ukraine. How we respond to the inflationary pressures will decide whether we fuel the problem or stifle it.
Deceptive Thinking
Rising prices only become problematic when prices including wages don’t rise at the same rate. We see nominal prices as much more of a problem than we do inflation adjusted prices.
Irving Fisher, the US economist, called this phenomenon the money Illusion. Even financial decision-makers find the illusion persuasive. They behave as if nominal prices are most important. Credit contracts, for example, are not inflation linked so the amount owed contracts under inflation.
Selective perception
Selective perception describes our inclination to ignore uncomfortable outside stimuli that contradict strongly held beliefs. This tendency is clear in our focus on nominal rather than real values. We concentrate on the familiar prices and wages rather on the actual circumstances.
In support of this behaviour, it has been shown that men focus more on the price of beer and fuel while women are more concerned about the price of milk.
People also have the tendency to exaggerate the likelihood of future events that are easy to picture. Israeli psychologists, Daniel Kahneman and Amos Tversky, were the first to document this cognitive bias.
If there is enough discussion about inflation, we imagine the situation spiralling into hyperinflation. This spurs inflationary expectations.
Inflation psychology has not taken hold
In Australia, inflation psychology has not yet taken hold. In a typical year, the Melbourne Institute surveys show that when inflation is at 2%, there is an inflation expectation of 4%.
Recent expectations increased to a peak of 6.7% when inflation had actually reached 6.1%. In July expectations declined to 6.3% and to 5.9% the following month, suggesting that citizens expect a fall in inflation.
The current inflation expectations are not out of synch with reality. So, it seems Australians are not letting fears of runaway inflation cloud their view.