Are Inflation Fears Contributing to Its Rise?

Headlines have been dominated by inflation’s stubborn rise, despite the Federal Reserve’s interest rate increases. There’s a school of thought that proposes that the very expectation that something, in this case inflation rising, can contribute to it actually happening. Why might that be? And what can investors do to prepare?

What’s the Theory? The Wage-Price Spiral

Simply put, if consumers expect that prices will be higher tomorrow than today, they are more likely to purchase now, even at an inflated rate. That creates an unvirtuous cycle of greater inflation down the road, as consumers continue to assume that prices will only go up: Why wait to buy?

A look at inflation trends in the 1970s and 1980s illustrates a phenomenon known as a wage-price spiral.¹

The cycle plays out like this: High inflation drives up inflation expectations, causing workers to demand wage increases to make up for the expected loss of purchasing power. When workers win wage increases, businesses raise their prices to accommodate the increase in wage costs, driving up inflation. The wage-price spiral means that when inflation expectations rise, it is difficult to bring down inflation.

Customers Grumble at Prices, but Still Buy

We can see how this spiral plays out with the recent swath of record earnings for many companies, thanks to price hikes. Consumers may grumble about higher prices, but if they continue to buy, companies are incentivized to keep raising prices until demand finally drops off.

One important U.S. industry that spiked during the pandemic has finally reached this turning point: used cars. Early in 2022, some used car prices actually outstripped the sticker price for equivalent new car models. The reason? New car customers had to patiently wait for delivery, owing to pandemic-related supply chain woes. Meanwhile, used car buyers could drive off the lot with their car the same day.

But in August and September, used car prices finally started dropping in earnest from their record highs. Car values ultimately fell 14% in 2022.²

Time will tell if this trend continues, and if other household expenses will follow suit.

Why Do Inflation Expectations Matter? Human Biases at Work

Behavioral economics helps explain how our group behavior helps influence the rise and fall of prices. It’s called “herd mentality,” and the pandemic has provided many examples of herd behavior, from the explosion of “meme stocks” to the rise (and fall) of cryptocurrency. All depended on investors moving en masse in one direction and then the opposite.

Herd mentality is, simply, people’s tendency to copy what others are doing. It’s FOMO (fear of missing out) in action: The herd chased, for example, Bitcoin prices while they reached a record high of nearly $69,000 in November 2021. Prices dipped below $16,000 by the next November. By February, the price of the volatile cryptocurrency was over $24,000.³

Under difficult financial circumstances—such as inflation or economic turbulence generally—there are some emotional tendencies that hurt us, says Professor Cass Sunstein of Harvard University. “The first one is present bias, which means we focus on today and tomorrow, but not the long term.”

Sure, inflation in 2022 was at 40-year highs. But will that still be the case a few years from now? While thinking about the next two months is good, “thinking about the next two years or five years is better,” Professor Sunstein says.

Apply “Decision Hygiene” to Your Finances

First to keep in mind: Inflation will continue to be a chief concern for the near future, and it’s important to address those fears while mitigating decisions based on the current economic situation, which won’t necessarily be true a few years from now. Financial planning must always focus on the long term.

Another step, as Professor Sunstein recommends, is to apply “decision hygiene.” Setting guidelines, listening to “the wisdom of crowds” and considering all the variables of a situation, rather than only one, can help you make cleaner financial decisions.

Creating a plan using precommitment strategies and sticking to it often is the best way to offset a herd mentality or really any type of behavioral bias.

Looking Ahead

Regardless of whether or not expecting something to happen influences it truly coming to pass, staying aware of the biases that can affect decision-making is a good way to keep them from interfering with it, especially when it comes to investing and financial planning.

One more important thing to keep in mind: While inflation topped out at more than 9% year over year in June 2022 (a 40-year-high), there are reasons to think that, over time, the size and speed of the rise will be considered an aberration. Investors should carefully consider assumptions that inflation will be as large a concern five years from now.