{"id":12155,"date":"2022-09-06T01:35:37","date_gmt":"2022-09-05T15:35:37","guid":{"rendered":"https:\/\/rationalemagazine.com\/?p=12155"},"modified":"2022-09-06T01:35:37","modified_gmt":"2022-09-05T15:35:37","slug":"inflationary-psychology-could-make-things-worse","status":"publish","type":"post","link":"https:\/\/rationalemagazine.com\/index.php\/2022\/09\/06\/inflationary-psychology-could-make-things-worse\/","title":{"rendered":"Inflationary psychology could make things worse"},"content":{"rendered":"

With the world experiencing inflation levels not seen since the 1980s, central banks are caught between warning of the dangers of an 1970s-style inflationary spiral, and contributing to that spiral by talking about it.<\/span><\/p>\n

It\u2019s a problem in any part of the economy where expectations shape outcomes. On one hand, central banks including Australia\u2019s Reserve Bank say they fear the return of <\/span>\u201cinflation psychology\u201d<\/span><\/a> \u2013 in which expectations of high inflation drive high inflation.<\/span><\/p>\n

The Bank of International Settlements (the central bank for national central banks) warned in its <\/span>2022 annual economic report<\/span><\/a>: \u201cWe may be reaching a tipping point, beyond which an inflationary psychology spreads and becomes entrenched. This would mean a major paradigm shift.\u201d<\/span><\/p>\n

Such warnings, known as <\/span>\u201copen mouth operations\u201d<\/span><\/a>, are part of a central banker\u2019s policy toolkit, the hope being that people will heed the threat and moderate their spending, negating the need for the painfully blunt instrument of hiking interest rates even more.<\/span><\/p>\n

On the other hand, the very notion of inflationary psychology is bound up in people being emotional, and not necessarily susceptible to \u2018rational\u2019 persuasion.<\/span><\/p>\n

As behavioural economists, we can see the dilemma in warning about inflationary psychology, given the very concept is about self-fulfilling prophecies.<\/span><\/p>\n

The inflation we are facing is real, caused mainly by supply shortages due to COVID and Russia\u2019s invasion of Ukraine. It is how we respond to them that either fuels or chokes further inflation.<\/span><\/p>\n

Cognitive illusions<\/b><\/h3>\n

Behavioural economists know that whereas rising prices needn\u2019t be a problem so long as all prices (and wages) are climbing at the same rate, we notice nominal stated prices much more than we notice real (inflation-adjusted) prices.<\/span><\/p>\n

In the 1920s, US economist Irving Fisher dubbed this <\/span>\u201cthe money illusion\u201d<\/span><\/a>. Nobel Prize winners <\/span>Akerlof and Shiller<\/span><\/a> have demonstrated that the phenomenon is widespread.<\/span><\/p>\n

Even professional decision makers behave as if nominal prices matter most. Loan contracts, for example, are usually not indexed to inflation, meaning the real value of what\u2019s owed usually shrinks.<\/span><\/p>\n

Selective perceptions<\/b><\/h3>\n

Focusing on nominal rather than real values gets entangled with selective perception. We focus on what matters most to us, so we mainly consider the prices (and wages) we are familiar with.<\/span><\/p>\n

This is demonstrated by behavioural experiments showing women are more likely to focus on the price of milk and men on the price of <\/span>beer and fuel<\/span><\/a>.<\/span><\/p>\n

Another cognitive bias is the <\/span>availability heuristic<\/span><\/a> \u2013 the mental shortcuts we make to assess the probability of future events.<\/span><\/p>\n

This phenomenon was first identified by Israeli psychologists Daniel Kahneman and Amos Tversky. People tend to exaggerate the likelihood of events they find easy to imagine \u2013 such as being killed by a shark.<\/span><\/p>\n

So much talk about the threat of inflation, and powerful images of hyperinflation \u2013 such as people wheeling wheelbarrows full of cash \u2013 can similarly influence people\u2019s expectations.<\/span><\/p>\n

Inflation psychology missing<\/b><\/h3>\n

So far, there\u2019s not much inflation psychology in Australia. Typically the Melbourne Institute\u2019s survey of inflation expectations has come up with an annual rate of about 4 per cent at times when actual inflation has been about 2 per cent.<\/span><\/p>\n

Recently, expectations have climbed with actual inflation to peak at 6.7 per cent when actual inflation was 6.1 per cent.<\/span><\/p>\n

Since then, in July and August, inflation expectations recorded by the survey have declined, to 6.3 per cent in July and 5.9 per cent in August. Taken literally, this means Australians expect inflation to fall.<\/span><\/p>\n

More confidently we can say that consumers\u2019 expectations are in line with reality, rather than above it as has traditionally been the case.<\/span><\/p>\n

The world would be a much easier place for central banks if people were rational. They are not, but for the moment \u2013 based on what they are saying \u2013 they don\u2019t seem to be getting carried away. <\/span><\/p>\n

This article was co-authored by Robert Hoffmann, Professor of Economics and Chair of Behavioural Business Lab at RMIT University.<\/i><\/b><\/p>\n

This article was originally published in\u00a0<\/i><\/b>The Conversation<\/b><\/a>. It is republished under Creative Commons.<\/i><\/b><\/p>\n

Photo by Mar Cerdeira<\/a> on Unsplash.<\/strong><\/em><\/p>\n","protected":false},"excerpt":{"rendered":"

With the world experiencing inflation levels not seen since the 1980s, central banks are caught between warning of the dangers<\/p>\n","protected":false},"author":572,"featured_media":12159,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"_monsterinsights_skip_tracking":false,"_monsterinsights_sitenote_active":false,"_monsterinsights_sitenote_note":"","_monsterinsights_sitenote_category":0,"footnotes":""},"categories":[63],"tags":[455,430,454],"coauthors":[452],"class_list":["post-12155","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-philosophy","tag-behavioural-economics","tag-economic-theory","tag-inflation"],"acf":[],"aioseo_notices":[],"_links":{"self":[{"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/posts\/12155","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/users\/572"}],"replies":[{"embeddable":true,"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/comments?post=12155"}],"version-history":[{"count":3,"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/posts\/12155\/revisions"}],"predecessor-version":[{"id":12158,"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/posts\/12155\/revisions\/12158"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/media\/12159"}],"wp:attachment":[{"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/media?parent=12155"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/categories?post=12155"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/tags?post=12155"},{"taxonomy":"author","embeddable":true,"href":"https:\/\/rationalemagazine.com\/index.php\/wp-json\/wp\/v2\/coauthors?post=12155"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}