Inflationary Psychology

What Is Inflationary Psychology?

Inflationary psychology is a state of mind that leads consumers to spend more quickly than they otherwise would in the belief that prices are rising. 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 can become 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.

Understanding Inflationary Psychology

Inflationary psychology essentially refers to the apparently positive feedback between currently rising prices and consumers' expectations that prices will continue to rise in the future. Inflationary psychology rests 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 of how exactly inflationary psychology works. Some economists describe inflationary psychology simply as a normal response to rising prices, based on theories of adaptive expectations or rational expectations; that consumers form their expectations of future inflation based (respectively) on their observations of recent inflation and their mental models of how economic variables such as interest rates and monetary policy determine inflation. 

Keynesian economists describe inflationary psychology in terms of irrational "animal spirits" or more-or-less irreducible waves of optimism or pessimism. Behavioral economics, on the other hand, describes inflationary psychology more in terms of cognitive biases such as availability bias. 

Managing Inflationary Psychology

Depending on how one explains inflationary psychology, the implications as to whether it is a problem or what to do about it can be quite different. If inflationary psychology is simply a rational response to current economic conditions or policies, it may not be a problem at all, and it could be the appropriate response to address the economic conditions or policies that are causing inflation.

If, on the other hand, one views inflationary psychology primarily as some kind of irrational or emotional response by market participants, an active policy response to manage or even fight against market sentiment might seem more attractive.

Central banks are always vigilant about the development of inflationary psychology, including the Federal Reserve (Fed), which faced 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 lead a nation’s central bank to raise interest rates in an attempt to put the brakes on the economy. Inflationary psychology, if unchecked, can also lead to bubbles in asset prices in due course.

Example of Inflationary Psychology

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 Impact on Investments

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, meanwhile, 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.