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DEFINITION of 'Inflationary Psychology'

A state of mind that leads consumers to spend more quickly in the belief that prices are rising. Inflationary psychology becomes a self-fulfilling prophecy, because as consumers spend more and save less, the velocity of money increases, further boosting inflation and contributing to inflationary psychology. Central banks such as the Federal Reserve are always vigilant about the development of inflationary psychology, having successfully combated high inflation that was rampant in the 1970s and 1980s. Inflationary psychology can have negative effects on the economy, as the resultant inflation spike may led a nation’s central bank to raise interest rates in an attempt to put the brakes on the economy.   

BREAKING DOWN 'Inflationary Psychology'

Inflationary psychology, if unchecked, can also lead to bubbles in asset prices in due course. Most consumers will spend their money on a product immediately if they think its price is going to increase shortly. The rationale for this decision is that consumers believe they can save some money by buying the product now rather than later.

Inflationary psychology was evident in the U.S. housing market in the first decade of this millennium. As house prices went up year after year, investors became conditioned to believe that “house prices always go up.” This led millions of Americans to jump into the real estate market either for ownership or speculation, which greatly reduced the available stock of housing and drove up prices sharply. This in turn attracted more homeowners and speculators to the U.S. real estate market, with the feeding frenzy only abating with the onset in 2007 of the worst financial crisis and housing correction since the 1930s Depression.

Inflationary psychology in the broad economy can be gauged by such measures as the consumer price index (CPI) and bond yields, which would spike up if inflation is expected to rise. The effect of inflationary psychology is different on various assets. For example, gold and commodities may rise in price since they are perceived as inflation hedges. Fixed income instruments would decline in price because of the prospect of higher interest rates to combat inflation. The effect on stocks is mixed but with a lower bias. This is because the impact of potentially higher rates is much greater than the positive effect on earnings by companies that have the pricing power to increase prices in an inflationary environment.

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