Behavioral New World
January 1, 2023
Inflation redux
I first wrote about inflation one year ago in the January 1, 2022, newsletter. Strangely (or perhaps not), inflation hasn't gone away yet. In fact, it seems to be a bigger celebrity than ever, showing up almost daily in the headlines. And for good reason: the current high level of inflation has serious consequences for all of us.[1] Perhaps it's a good time then to revisit this ubiquitous economic phenomenon.
Let’s start with basic concepts about inflation, ideas not necessarily related to behavioral economics.
The most used measure of inflation in the United States is the Consumer Price Index (CPI). It is not a measure of the inflation rate—it is an index (as in “Consumer Price Index”). For example, the CPI in November was 297.711.[2]
Changes in the CPI are the reported inflation rate. Here’s a simple example. If the CPI was 105 at the end of November and 100 at the end of October, the inflation rate for November was 5%. That’s: (105 – 100 / 100) = 0.05 = 5%.
That’s a monthly inflation rate. Inflation rates reported in the press are typically annual rates, that is, annual changes in the CPI. From November 2021 to 2022, for example.
Important: If the inflation rate is going down but still positive, prices (price indexes) are still going up; they’re just going up at a slower rate. If the inflation rate is negative (a rare occurrence), then overall prices are declining.
Vocabulary: “Disinflation” means the inflation rate is going down, but still positive. “Deflation” means that prices are doing down. Such a decline is rare in the CPI, although the prices of individual components of the CPI “bundle” may be declining (more below on how the CPI is calculated).
Now let’s see what behavioral economics has to say about inflation.
First, pay attention to the way inflation is described. Consider this recent headline: “Inflation eased to 7.1% in November.” Ah, “ease.” Sounds like everything is going just fine. But an alternative, equally factual, characterization would be, “Inflation remains at a four-decade high.” In the language of behavioral economics, the same information can be “framed” in different ways (framing will be the topic of a future newsletter).
The choice of descriptors might not be random. For example, in the past election cycle in the U.S., some news sources wanted to emphasize inflation, characterize it as out of control, and point the finger of blame. Other news sources wanted to downplay the importance of inflation and focus attention on other issues. (I think you can figure out the players without a program.)
It is thus important to sample across news sources with different leanings to get a less emotional view of inflation, assuming that opposite hysterias cancel out. Sampling across news sources will also provide you a more balanced view of other issues (immigration, climate change, etc.). As a bonus, scanning across the spectrum of views reduces the chances that you’ll succumb to confirmation bias, the subject of the May 2022 newsletter.
Second, know that the reported inflation rate may be higher or lower than your personal inflation rate. The CPI is calculated using a presumably representative bundle of goods and services. But, for example, if you have a long commute, gas might be a bigger part of your budget than is represented in the CPI. And, conversely, smaller if you bike to work.
If you have some sense of your household budget, you can calculate your personal inflation rate—just google “personal CPI.” The purpose of calculating your personal inflation rate is to give you a more realistic of the inflation rate that you are experiencing.
Third, here in the U.S. and in other countries, policy makers were slow to react to the rise in inflation. Why? In part, because of the something called the “recency effect” or “recency bias.” As the phrase suggests, people tend to give too much weight to recent events or trends. The consequences? Consider this report from June 2022:
US Treasury Secretary Janet Yellen admitted Tuesday that she had failed to anticipate how long high inflation would continue to plague American consumers as the Biden administration works to contain a mounting political liability.
“I think I was wrong then about the path that inflation would take,” Yellen told CNN’s Wolf Blitzer on “The Situation Room” when asked about her comments from 2021 that inflation posed only a “small risk.”[3]
She was not alone, far from it. The Federal Reserve, the central bank of the United States, primarily responsible for monetary policy, also downplayed the possibility of sustained inflation until reality intruded. In 2021, its members repeatedly characterized inflation as “temporary.”
If, as Mark Twain said, “History doesn’t repeat itself, but it often rhymes,” we can hope to learn from history. But that may be difficult:
When Janet Yellen testified before a congressional commission almost a decade ago about the 2007-2009 global financial crisis, an interlocutor noted that she seemed to have seen trouble brewing in banks and mortgage markets before most others. In truth, she said, she hadn’t put the pieces together fast enough to stop the ensuing disaster.[4]
(Yellen was Federal Reserve vice chair at the time.)
It might seem that I’m picking on Dr. Yellen. I’m not—she’s smart and probably spends most of her waking hours thinking about inflation and the economy (and, again, she was not alone in underestimating the persistence of inflation.) My point is rather to emphasize how difficult it is to forecast, in part because of our all-too-human cognitive biases. And how difficult it is to learn from history.
Two other phenomena help explain the slow policy response to rising inflation. I discussed extrapolative expectations a year ago. As I wrote then: “Simply put, people believe that recent trends will continue. Extrapolative expectations are important because inflation can become a self-fulfilling prophecy.”
Also, the availability bias is at work here because recent inflation is readily available information, that is, is easily retrievable and at thus at the forefront of our minds. Obviously there can be overlap between the recency and availability biases.
How can we use our understanding of these behavioral tendencies to make better decisions? First, we can get a less emotion-infused view of inflation by sampling different news sources thereby avoiding a distorted reaction to inflation news.
Second, we can estimate our personal CPI which will give us a household-specific inflation rate. Maybe things aren’t as bad as reported—we’re off the grid and the vegetable garden is thriving. Or maybe things are worse, and we need to take some drastic action (e.g., cutting back on spending, renting out the kids).
Third, understanding that we have these biases, we can be better forecasters if we step back and ask how these biases are influencing our thinking. Yes, forecasting is tough. As Yogi Berra (or Mark Twain or Niels Bohr or …) said, “Prediction is difficult, especially about the future.” But forecasting is necessary to good financial planning, and better forecasts make for better outcomes.
So where do I—as a behavioral economist but not a monetary expert—think inflation is headed? I’ve taken some time this morning to (try to) put aside my recency, availability, and other biases. That (hopefully) accomplished, I choose to focus on Federal Reserve policy, although, as I wrote a year ago, there are many causes of inflation.
Drum roll, please. My view is that inflation will moderate the first part of this year (that is, the inflation rate will decline) but tick up in the latter part of the year. My reasoning? As prices moderate, the Fed will ease up a bit too much on the inflation fight, reflecting recency effects and extrapolative expectations. (Important: This prediction is not investment advice.)
Best wishes for a prosperous 2023!
[1] Recall from the rule of 72 that a 7% inflation rate means that the CPI will double in approximately 10 years. See the April 2021 newsletter, “Exponential growth bias.”
[2] There are many different CPIs. This one is “All items in U.S. city average, all urban consumers, not seasonally adjusted.” If you are having trouble sleeping at night, you can find them here: https://www.bls.gov/data/
[3] https://www.cnn.com/2022/05/31/politics/treasury-secretary-janet-yellen-inflation-cnntv/index.html
[4] https://www.wsj.com/articles/janet-yellens-learning-curve-11666364190?page=1
Unfortunately, the article is behind a paywall, so you’ll just have to take my word for it.
Inflation redux
I always think things like inflation that have a global effect will take longer to get better (or worse). Not because I am brilliant at eliminating my biases but because of what I remember from my past. My parents built a house in the mid-seventies and had a double-digit interest rate on the mortgage. They were delighted years later when they got it refinanced for only 8%! (refinancing was a bit harder then, and you paid more "points" to do it). I started my technology business right before the dot com bust and was running it when the 2007-8 crash happened. Each time, it took three years or so before a new "normal" settled in, and you just had to work your ass off to get through it. I also remember working with a local bank in 2006 that was expanding like the real estate growth would never end. I took their money but refused to put my money in their bank as I knew it would all come to a bad end (although I didn't realize how bad). In 2008, they underwent FDIC receivership and were sold off in pieces. Given all that is happening, I think that we will be lucky if inflation settles into a "normal" in the next three years. I'll check back in 2026...