What is Inflationary Psychology?
Inflationary psychology is a mindset that causes consumers to spend faster than they otherwise would in the belief that prices are rising. Most consumers will immediately spend their money on a product if they think its price will increase shortly. The rationale for this decision is that consumers believe they can save money by purchasing the product now rather than later.
Inflationary psychology can become a self-fulfilling prophecy because as consumers spend more and save less, the velocity of money increases, inflation and contributing to inflationary psychology.
Key points to remember
- Inflationary psychology refers to the role that the psychology of investors, consumers, and other market participants play in the inflation process.
- Economists have described inflationary psychology in terms of rational expectations, irrational emotional factors, or distinct cognitive biases, with different conclusions for market implications and policy responses.
- Inflationary psychology can contribute to persistent and problematic inflation in an economy or potentially disruptive asset price bubbles.
Understanding Inflationary Psychology
Inflationary psychology basically refers to the seemingly positive feedback between the current rise in prices and consumer expectations that prices will continue to rise in the future. Inflationary psychology is based on the rather obvious basic idea that if prices are rising and have risen in the past, then many people will expect prices to continue to rise in the future.
Economists have developed various models on exactly how inflationary psychology works. Some economists describe inflationary psychology simply as a normal response to rising prices, based on theories of adaptive expectations Where rational expectations; that consumers form their expectations of future inflation based on (respectively) their observations of recent inflation and their mental models of how economic variables such as interest rates and monetary policy determine the inflation.
Keynesian economists describe inflationary psychology in terms of irrational “animal spirits” or more or less irreducible waves of optimism or pessimism. Behavioral economicson the other hand, describes inflationary psychology more in terms of cognitive biases such as availability bias.
Managing Inflationary Psychology
Depending on how inflationary psychology is explained, the implications of whether this is a problem or what to do about it can be very different. If inflationary psychology is just a rational response to economic conditions or policies, it may not be a problem at all, and it might be the appropriate response to deal with economic conditions or policies that are causing inflation.
If, on the other hand, inflationary psychology is seen primarily as a kind of irrational or emotional response by market players, an active policy response to manage or even fight against Market sentiment might seem more appealing.
Central banks are always alert to the development of inflationary psychology, including the Federal Reserve (Fed), which faced high inflation that plagued the 1970s and 1980s. Inflationary psychology can have negative effects on the economy, as the resulting spike in inflation can cause the central bank to a country to rise interest rate in an attempt to rein in the economy. Inflationary psychology, if left unchecked, can also lead to bubbles asset prices in due time.
Example of inflationary psychology
Inflationary psychology was evident in the US housing market during the first decade of this millennium. As house prices rose year after year, investors were conditioned to believe that “house prices always go up”.
This led to millions of Americans jumping into the immovable market for property or speculation, which has sharply reduced the stock of available housing and pushed up prices sharply. This in turn drew more homeowners and speculators into the US housing market, with the feeding frenzy only easing with the onset in 2007 of the worst financial crisis and the worst real estate correction since the depression of the 1930s.
Impact of Inflationary Psychology on Investments
The effect of inflationary psychology is different on various assets. For example, gold and goods may increase in price since they are perceived as hedges against inflation. Fixed income the instruments, meanwhile, would fall in price due to the prospect of higher interest rates to fight inflation.
The effect on equities is mixed but with a lower bias. Indeed, the impact of potentially higher rates is much greater than the positive effect on earnings by companies that have the pricing power raise prices in an inflationary environment.