Inflation psychology

‘Inflation psychology’ was the topic of a recent inflation update by Stephen Cecchetti (h.t. Freakonomics blog). In it he mentions that people seem to have selective memories regarding price changes – namely people are likely to remember price increases more than price falls.

I once mentioned such a potential bias when I commented on Kiwiblogblog, it is a bias that I definitely hold, and I suspect other people do too. For example, did you know that the nominal New Zealand price of petrol is only starting to reach the level recorded in July 2006 now? People often remember the big increase in petrol prices in mid-2006 and late 2007, but they seem to forget about the significant fall in prices that occurred between these periods.

The question then is, what does this bias imply for inflation?

Well as far as I can tell, this bias could influence inflation through its impact on inflation expectations. Inflation is the increase in the general price level. Given stickiness in prices, and the inability to observe other firms’ current prices, the path of inflation depends significantly on household and firm inflation expectations.

Now, if these inflation expectations are subject to a cognitive bias whereby people either weight certain products too heavily, or pay more attention to price increases than decreases this will bias the inflation expectations influencing the inflation rate. In the case of paying relatively too much attention to price increases, this will bias up inflation expectations – making it more difficult to hold inflation down.

This impact will be most severe when:

  • It involves goods that many people buy,
  • The variance from the general price level of individual prices is especially severe

Currently we are in a situation where food and oil (goods that are part of most households consumption bundle) prices are rising relatively quickly – in fact at a much faster rate than the general price level. If this cognitive bias exists, then we would expect inflation expectations to begin to increase now. We will see whether this is the case when the RBNZ survey of expectations is released today.

  • CPW

    I read once that part of the problem is that people only purchase durable goods, which tend to be the things most likely to be falling in price (e.g. cars, lcd tvs) rarely, and hence they underestimate their impact on the total price level.

    The marketscope survey of inflation expectations put out by the RB suggests that consumers tend to overestimate the CPI consistently by 1-1.5%pa. Maybe this is why people believe that real wages are often falling.

  • Hi CPW,

    What you said is all very true.

    The one counter-argument that might come up is if someone states that we ‘under-estimate inflation’ – therefore its not the household and firms with a biased outlook, but economists.

    “Maybe this is why people believe that real wages are often falling.”

    Indeed. Very interesting.

  • CPW

    I personally believe that CPI measures tend to understate inflation and that over the long-run real wage growth has probably been a lot stronger than traditional estimates suggests – mainly because CPI measures probably fail to measure quality improvements and substitution effects correctly. From memory one common estimate suggests this adds 1%pa to the “true” CPI in the US, I don’t know if the result for NZ would be similar.

  • CPW

    whoops that first post should have said “purchase durable goods infrequently”

  • “I personally believe that CPI measures tend to understate inflation and that over the long-run real wage growth has probably been a lot stronger than traditional estimates suggests”

    I’m confused, if CPI understates inflation, then wouldn’t real wage growth be weaker then we currently have on record?

  • CPW

    Man I’m struggling today! Should have been “overstate” not “understate”.

  • Ahhh cool, I do that sorta stuff constantly.

    Its all this damn work – its melting our brains!