Thinking About Inflation Leads to Inflation

Thinking About Inflation Leads to Inflation

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When perception leads to economic reality

Inflation is a term that now sends shivers down the spines of economists, policymakers, and everyday Kiwis alike.

It’s a financial enigma that erodes the value of money, disrupts financial plans, and casts an air of uncertainty on financial decisions, whether big or small.

But what if we told you that the very act of thinking about inflation could inadvertently contribute to more inflation? Let’s delve into the concept of inflationary psychology and whether it is impacting New Zealand’s economy.

Inflationary Psychology Explained

Inflationary psychology is a concept that is both fascinating and perplexing. It emerges when perceptions of future price increases lead to actions that inadvertently contribute to further inflation. The cycle creates a self-fulfilling prophecy where consumers and businesses, driven by the fear of imminent price hikes, adjust their behaviour in ways that amplifies the very inflation they are afraid of.

The United States is dealing with its worst inflation in almost 40 years, with the average American requiring an extra $5000 to live the same lifestyle they had last year. Richard Curtain, a leading economist at the University of Michigan, told The Hustle, “This is the complete dynamic that you need to develop inflationary psychology.”

As businesses raise prices in anticipation of higher costs and consumers hasten purchases to avoid future price surges, a feedback loop of rising prices and wages ensues, perpetuating the inflationary cycle. Financial markets, such as the share market, may anticipate further inflation and adjust interest rates accordingly. This collective response can inadvertently lead to increased supply and demand imbalances, which can amplify inflationary pressures.

To understand this phenomenon, let’s take a look at New Zealand’s current situation.

What’s Happening in New Zealand?

The New Zealand economy is showing signs of cooling and the Reserve Bank of New Zealand (RBNZ) announced it was holding the official cash rate (OCR) steady at 5.5 percent.

The RBNZ said in a statement that the economy is “evolving broadly” and the current level of interest rates is “constraining spending and hence inflation, as anticipated and required”.

Sectors of the economy that are more responsive to changes in interest rates are observing a gradual deceleration in activity, labour shortages are easing, and the relevant RBNZ Committee noted that house prices “appear to have stabilised” to the extent they predict nearly 10 percent growth within the next two years.

But there’s a warning the OCR could remain high for some time, and the RBNZ isn’t ruling out further rate hikes before the end of the year.

Stats NZ figures show New Zealand’s consumer price index declined to 6.0% in the 12 months to June 2023, compared to the 6.7% increase in the 12 months to March 2023 and the 7.2 percent increase in the 12 months to December 2022. But this is still a long way off the RBNZ’s 1 to 3% target range.

Kiwis are facing rising food prices, an increase in petrol prices, and many Kiwi homeowners are facing higher mortgage rates, alongside other living expenses, all factors which could play a role in inflationary psychology.

The Stats NZ figures for the June 2023 quarter showed consumer prices rose 1.1% and Nicola Growden, Stats NZ consumer prices senior manager, said prices were “still increasing at rates not seen since the 1990s”.

Growden said the biggest driver of annual inflation was food, which was up 12.3%, due to an increase in the cost of vegetables, ready-to-eat food, cheese, eggs, and milk.

The Committee says the tug-of-war between demand and supply is moderating in the New Zealand economy, but it’s warning a “prolonged period of subdued spending growth is still required to better match the supply capacity of the economy and reduce inflation pressure”.

“Headline inflation and inflation expectations have declined, but measures of core inflation remain too high,” the Committee said.

New Zealand has been through one of the most aggressive rate hiking cycles in history in a bid to beat inflation.

Pressure On Exports

On a global scale, economic expansion continues to lag it’s usual pace, and there has been a reduction in overall inflation rates among the majority of New Zealand’s international trading partners. However, core inflation remains stubbornly high in many countries.

The Monetary Policy Committee said, “weakening global economic growth is putting downward pressure on New Zealand export prices”.

The Committee discussed risks around the outlook for global growth in the medium term “and judged that these were skewed to the downside”.

“Over the medium-term, a greater slowdown in global economic demand, particularly in China, could weigh more on commodity prices and overall New Zealand export revenue.”

‘Revenge Spending’

Consumer psychology, influenced by emotions, fears, and coping mechanisms, plays a significant role in shaping consumption patterns that can drive inflation.

Lockdowns, border closures, fear-mongering and other issues during the pandemic triggered irregular consumption patterns like panic buying and impulse purchasing. This meant New Zealand’s inflation rate was already 5.9 percent (and climbing) in December 2021, before Russia’s invasion of Ukraine put even more pressure on the prices of food and petrol.

Juliana French, Head of Department of Marketing at Monash University Malaysia, says consumers can cause inflation in several ways.

“The 'end' of the pandemic saw a significant change in consumer behaviour in ‘revenge spending’ or ‘revenge buying’ – the increase in consumer buying after an unprecedented economic event.”

“Because the psychological perspective of disruptive life events caused by external factors is often not accounted for, it may be tricky for policymakers to find a solution to overcome this compared with price stabilisation policies to control inflation.”

Impulse buying was evident in many countries during the pandemic, and she says while impulse buying or ‘revenge spending’ may contribute to stronger economic growth, its effect on inflation is inevitable.

“The question is whether revenge spending is inducing a new trend of consumer behaviour leading to inflation.”

Learn more:

The Impact of Inflationary Psychology

The very act of thinking about rising inflation can wield a powerful influence, shaping behaviours and outcomes in a manner that defies traditional economic models.

Ways Inflationary Psychology Can Play Out

Wage Demands

If workers expect prices to rise rapidly, they may demand higher wages to sustain their purchasing power. These wage demands can put pressure on businesses to increase prices to cover the increased labour (staff) costs. As a result, higher wages can contribute to overall inflation.

Consumer Behaviour

When consumers believe prices will increase soon, they might rush to make purchases now to avoid higher costs later. This surge in demand can lead to shortages of goods and services, allowing businesses to raise prices due to increased demand, which can be referred to as "demand-pull inflation".

Business Pricing

Businesses may anticipate rising costs for materials, labour, or other inputs. In response, they might pre-emptively raise prices to protect their profit margins. This can lead to a cycle of price increases up and down the economy.

Investment Decisions

Investors might alter their investment strategies based on expectations of higher inflation. They might move away from their current investment mix and instead seek out assets that historically perform well during inflationary periods.

Central Bank Response

Inflationary expectations can influence how a central bank, like the RBNZ, conducts its monetary policy. If people expect high inflation, the central bank might feel compelled to raise interest rates to counteract it. This usually leads to subdued economic growth and lower employment.

The Bottom Line: A Delicate Tightrope

Central banks around the world, including the RBNZ, are tasked with the challenging mission of maintaining price stability while promoting economic growth and employment. However, the more central banks focus on taming inflation, the more complex the situation can become.

In the end, the puzzle of thinking about inflation leading to more inflation reminds us that economics is not just about numbers and data - it's about perceptions, expectations, and their real-world consequences.

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