Inflation
Behavioral New World
January 1, 2022
Behavioral economics and inflation
The economy is about to offer us a somewhat nasty start to the new year: inflation like we haven’t seen in a decade, or maybe even 30 years. I thought it might be helpful to offer a quick overview of the topic, including a few thoughts on its psychological aspects.
What is inflation? The standard answer is, “A general increase in prices,” and that will do for our purposes here.[1]
What causes inflation? There are many answers to that question which are not mutually exclusive. Your economics textbook likely distinguished between “cost-push” and “demand-pull” inflation. An example of cost-push inflation: Lumber is an input for house building. As lumber’s cost rises, perhaps because of weather, the price of building a new house rises.
An example of demand-pull inflation: People spent less during the first year and half of the pandemic; as lockdowns were eased, there was burst of spending that drove up prices.
So who’s to blame for inflation? Economist Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon…”, meaning that low interest rates and activities by the Federal Reserve (the central bank of the United States) influence inflation. Essentially he was saying that the Fed’s actions determine whether there is inflation or not. This explanation is not inconsistent with the dichotomy of cost-push and demand-pull inflation, which is affected by consumer behavior and hence has much more nuance. Bottom line: our own economic behavior has a lot to do with inflation.
Why is inflation important? The rule of 72, discussed in my April 2021 newsletter applies to inflation. The recent inflation rate of 6% means that it is only 12 years before your purchasing power is cut in half (assuming that inflation is persistent). Thus, an important issue is whether inflation is transitory or whether it will persist for an indefinite period.
Up until 2021, inflation had been relatively low in the United States for at least a decade. According to economist and professor Richard Kilbride, globalization, technology, and demographics have, until recently, kept inflation in check. In assessing the potential persistence of inflation, one can consider how these influences are changing.
What does this have to do with behavioral economics? Glad I asked. Answer: people’s expectations about the future path of inflation can also affect current inflation. For example, if consumers believe that the price of toilet paper is going to increase significantly in the future, they will buy more today, thus driving its price up today.
Thus, the way in which people form their expectations is another important determinant of inflation. There is a human tendency to have so-called “extrapolative expectations.” Simply put, people believe that recent trends will continue. Extrapolative expectations are important because inflation can become a self-fulfilling prophecy. A recent Wall Street Journal article was entitled, “How Do You Feel About Inflation? The Answer Will Help Determine Its Longevity” (December 13, 2021).[2]
However, self-fulfilling prophesies cannot be sustained indefinitely. At some point, it will be clear that the trend in inflation has changed. But figuring out when that will happen is terribly tricky. As the Wall Street Journal article says, “Psychology around inflation is hard to gauge.” And as Yogi Berra (or Mark Twain or Niels Bohr or …) said, “Prediction is difficult, especially about the future.”
Rather than rely too heavily on prediction, perhaps the best we can do is to assess how current inflation is affecting us – at a very personal level. As I note in my book The Foolish Corner, every individual or household has a “personal inflation rate,” which can deviate significantly from the Consumer Price Index (CPI), the most commonly cited measure of inflation. We’ll make better decisions with a more accurate assessment of our personal inflation reality.
Here are two tools for helping you calculate your personal inflation rate:
http://www.candaceshira.com/learning_center/calculators/personal_inflation_rate
All of us here in the U.S. have benefited mightily over the decades from a relatively low and contained rate of inflation. We are now about to see what the opposite of that might look like. Buckle up.
[1] [1] Some vocabulary: “deflation” is a decline in prices. “Disinflation” is a reduction in the inflation rate.
[2] An extended, technical investigation of extrapolative expectations can be found in The Behavioral Economics of Inflation Expectations: Macroeconomics Meets Psychology by Tobias R. Rotheli, Cambridge University Press, 2020.
I suspect inflation is here to stay for awhile...Seems everywhere you look SUPPLIES are constricted and DEMAND in terms of the number of dollars chasing those supplies is increasing. That is a textbook recipe for higher prices.