‘Inflationary Psychology’ Has Set In – Dislodging It Won’t Be Easy

There is a high probability that a self-perpetuating wage-price spiral will develop in the next few years. Households have already become less resistant to paying higher prices and firms have become less resistant to offering higher wages. Prices and wages will continue to spiral upward until the cumulative erosion in inflation-adjusted incomes causes the economy to collapse in recession. It is like the children’s game of musical chairs: Everyone knows the game will end, but they feel compelled to keep racing around the circle at an ever-faster pace hoping their forced exit will leave them in the best possible position—even if it still means an inflation-adjusted loss.

This situation has been termed “inflationary psychology.” Consumers purposely advance their purchases in order to beat anticipated future price increases. Firms readily pass along higher costs to consumers, including the future cost increases that they anticipate. That’s what happened in the last inflationary age, which started in 1965 and ended in 1982: Expected inflation became a self-fulfilling prophecy. Many commentaries assert that the current situation is nothing like the situation faced in 1978-80. That’s true, but irrelevant. The more apt comparison would be to the five to ten years prior to that period, when inflation had not yet reached crisis levels. Government officials claimed they had the policy tools that could easily reverse inflation, just as they claim now.

Those policies, however, repeatedly failed across administrations, from Lyndon B. Johnson’s surtax, to Richard Nixon’s wage and price controls, to Gerald Ford’s public relations “Whip Inflation Now” campaign, and Jimmy Carter’s fireside pleas to diminish material aspirations. Only after Paul Volcker was appointed Federal Reserve chair and raised the fed funds rate to 20% in 1980 did inflation begin to fall. He pushed up rates aggressively, by 10 percentage points in just six months. The resulting 10% unemployment rate was needed to reduce inflation by 10 percentage points.

Today’s mantra is, “This time is different.” Supply disruptions were said to be transient, and the inflation rate would soon fade. The University of Michigan’s survey confirmed that shortages were important, and those shortages played an initial role in raising inflation expectations. Awareness of shortages has remained high, mentioned by half of all consumers in the past nine months. Nonetheless, shortages are no longer associated with higher inflation expectations—their inflation expectations now differ by less than one-tenth of a percentage point.- READ MORE