‘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.