What is inflationary psychology and how does it affect our rising cost of living?

In early September, Reserve Bank Governor Philip Lowe began his annual address to the Anika Foundation, discussing inflation and the country’s future prospects.

It was two days after the RBA’s governor confirmed the country’s fifth consecutive hike in the country’s cash interest rates.

“After several years of below target inflation, it is now significantly above target and is expected to rise even higher in the near term,” said Mr Lowe.

“The magnitude of this reversal in inflation came as a surprise to many, including us” [at the RBA].”

His speech pointed to causes such as the impact of the Russian invasion of Ukraine on supply chains, rising fuel costs and general uncertainty about the economic state of the world.

However, Mr Lowe also pointed to the potential implications of another lesser-known concept: inflation psychology.

“However, there’s something here worth looking at that can’t be easily captured in our standard models — and that’s the general inflation psychology in the community,” he said.

“If workers and companies start to expect higher inflation, and wage growth and pricing behavior adjust accordingly, the task of walking that narrow path will be very difficult, if not impossible,” he added later.

A red sign lists the cost of gasoline, while a man in the distance fills his car.
Fuel costs were tipped as a major factor in the recent rise in inflation.(Getty Images: Bai Xuefei/Xinhua)

Meg Elkins, a behavioral economist at the RMIT School of Economics, Finance and Marketing, agrees that this consumer mindset can have a significant impact on inflation.

“The idea of ​​inflation psychology is that we respond to high prices by buying now rather than delaying our purchases because we think prices will rise in the future,” Dr. Elkins to ABC RN’s The Money.

Mr Lowe also said that if inflation expectations shifted upwards, higher interest rates would be needed to address this, resulting in a “sharper slowdown in the economy”.

“It is in our national interest that we avoid this.”

This ominous reference came less than three months after Mr Lowe raised similar concerns about the psychology of inflation. A fear that was itself echoed five days later by the Bank of International Settlements – the bank for the world’s central banks.

The recent rise in US inflation has also worried some analysts.

Still, these recent concerns from Mr. Lowe and others suggest that our interpretation of inflation could have a similar impact on the size and duration of inflation itself.

What exactly is inflation?

Basically, inflation is when the price of goods and services starts to rise.

In a healthy economy, production output grows and shrinks over time, with this rise and fall depending on employment rates, wage growth and consumer spending.

When an economy is recovering, it usually means that more people will buy goods and services.

This can lead to excessive demand for certain items. If this demand begins to exceed the available supply, the cost for that item can rise, known as inflation. Another cause of inflation is when the supply of an item falls below the demand.

But while inflation is a normal phenomenon, it can rise at worrying rates in some cases. According to the latest statistics, inflation in Australia is growing the fastest in more than two decades.

During the 1970s, when the infamous period of “stagflation” occurred, the CPI rose from 2.1 percent to 17.7 percent over a five-year period.

Wait, what’s the CPI?

The CPI is the consumer price index, which is basically a quantification of inflation.

Every three months, the Australian Bureau of Statistics publishes its inflation figures, including an annual CPI.

According to ABS figures at the end of June, the annual CPI was at 6.1 percent, with high fuel costs and an abundance of unfinished homes being the main contributors to this figure.

For context, this figure was 3.8 percent in June 2021.

Middle-aged man with glasses stands next to a marble wall
Over the past three months, RBA Governor Philip Lowe has expressed fears about rising inflation perceptions. (ABC News: John Gunn)

Due to this increase, the cash rate – the interest at which banks lend to each other – has risen in recent months.

In fact, the RBA raises the spot rate as a means of cooling the economy by discouraging spending, with a target range of 2 to 3 percent.

The RBA thinks Australia will reach 3 percent by 2024 at the earliest.

But when we reach that figure, economists also say that depends on our perception of inflation.

So how does inflation psychology work?

dr. Elkins said the basic mechanism of inflation psychology is that it is a self-fulfilling prophecy.

“What’s happening is that if prices go up, we feel like they’re going to keep going up. So we need to get in now, instead of waiting for them to go up in the future. And by doing that, you’re artificially pushing prices up,” she says.

At the moment, Australia does not expect inflation to rise significantly – with inflation expected falling from 6.3 percent in July to 5.4 percent in September, according to the latest figures from the Melbourne Institute.

But under this pretense, if people assumed inflation would rise exponentially higher, it could result in a higher-than-expected CPI.

So why are people talking about this now?

One suggestion is that the RBA is well aware that markets are closely monitoring and reacting to its actions.

dr. Elkins said the reason Mr Lowe refers to inflation psychology is likely related to raising awareness among the general public.

“It is used sparingly, so that [it can] have the greatest impact. So if you know Philip Lowe talks about this sort of thing, [the RBA is] particularly concerned, and it’s a full warning,” she says.

But couldn’t talking about it increase the chances of it happening?

dr. Elkins doesn’t think no, but attributes it to “availability bias”. This phenomenon means that something comes up because it is talked about so much.

She gives the example of the high price of iceberg lettuce.

“The interesting thing about that is that you might not think about an iceberg lettuce in your day-to-day life, but all this media around an iceberg lettuce and it’s in your head.”

It explains why crisp green leaves have suddenly become a conversation starter.

Is there anything I should do?

dr. Elkins suggests keeping an eye on real rates rather than interest rates.

“The [figures] what we really need to pay attention to is actually real wages and real interest rates because they tell us the truth about what’s happening in the economy right now,” she says.

“If we can get acquainted with that real [inflation rates] and those real interest rates, then we actually know what’s going on in the economy around us.”

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