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.
It’s a problem in any part of the economy where expectations shape outcomes.
On one hand, central banks including Australia’s Reserve Bank say they fear the return of “inflation psychology” – in which expectations of high inflation drive high inflation.
The Bank of International Settlements (the central bank for national central banks) warned in its 2022 annual economic report: We may be reaching a tipping point, beyond which an inflationary psychology spreads and becomes entrenched. This would mean a major paradigm shift.
Such warnings, known as “open mouth operations”, are part of a central banker’s 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.
On the other hand, the very notion of inflationary psychology is bound up in people being emotional, and not necessarily susceptible to “rational” persuasion.
As behavioural economists, we can see the dilemma in warning about inflationary psychology, given the very concept is about self-fulfilling prophecies.
The inflation we are facing is real, caused mainly by supply shortages due to COVID and Russia’s invasion of Ukraine.
It is how we respond to them that either fuels or chokes further inflation.
Cognitive illusions
Behavioural economists know that whereas rising prices needn’t 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.
In the 1920s, US economist Irving Fisher dubbed this “the money illusion”.
Nobel Prize winners Akerlof and Shiller have demonstrated that the phenomenon is widespread.
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’s owed usually shrinks.
