Lab research shows inflation may be all in your mind: Don Pittis

Inflation is all your head, and Luba Petersen has the lab workto prove it.

Canadian inflation has cooledto near one per cent and Bank of Canada governor Stephen Poloztells us to expect interest rates to stay low.

With a flood of money into the world economy, that wasn't supposed to happen, but a growing body of research shows the rate of inflation may bemore mental thanmechanistic.

When I heard about Petersen's laboratory work on inflation, my mind involuntarily strayed to rats in cages.

But of course the professor and researcher at Simon FraserUniversity is using human subjects to try to understand what causes prices and wages to rise.

"The problem with looking at real-world data is that you don't know what's driving people's behaviour," says Petersen. "But in the lab I have a lot of control."

She says that high degree of control gives her the ability to experiment with new policies, because central banks can't toy with policy just for the sake of academic inquiry.

Petersen's research is part of the behavioural revolution in economics. Rather than theorizing how people shouldreactto economic signals, economists experimentto find outhow people actually respond.

The researcher can't talk about her experiments commissioned bythe Bank of Canada, but other work shows some unexpected reactions to central bank attempts to push prices and wages higher.

Deflation's a drag

Not just Canada, but much of the developedworldis suffering low inflation or even deflation, which, for reasons previously discussed, acts as a drag on investment and growth.

Manipulative as it may seem, one way central bankers try to ignite inflation is to tell people they should expect it. But Petersen's research indicatesthat exactly how they try to do that really matters.

Essentially what she found is that if central bankers predict ahigher inflation targetand the economy fails to hit that target, people become cynical and lose confidence in the bank's predictions.

However, Petersen'sresearch shows that if they make far less explicit "qualitative" warnings about rising prices and wages, they are more likely to be believed.

The traditional theory one that many still ascribe to is that low interest rates make money cheap. Then people feel free to borrow, investand spend, thus strengtheningthe economy. That drives inflation up.

Perverse effect

But a behavioural analysis suggested by Chicago Fed economist Leonardo Melosipresents a different view. Ifpeoplethink of the central bank as having privilegedinformation about the economy and its future, the bank can mistakenlysendthe wrong message.

"When they set low interest rates, that suggests to the public that the Fed is pessimistic about thefuture state of the economy," says Petersen. Even if a central bank is not pessimistic, such a signal could inadvertently have the perverse effect of convincingpeople and businesses "to save more and spend less."

University of Alberta economist Constance Smith points out that the inflationary effect of the current money glut may still be slowly working its way throughthe system. "This can take years."

• Inflation cools to 1.1%
• Savers must adjust retirement plans

However, if inflation is created in our mind by our expectations, then last week's comments by Polozthat retirees should expect interest rates to be "lowerforlonger" will just make people, especially those saving for retirement,clutch their money more tightly.

"He's been saying that rates are going to stay low, so I assume he thinks inflation is going to stay low," says Smith. Once again, she says, that makes retirees want to save more and spend less.The fact that they think inflation will be low helps create low inflation.

In a world where inflation isall in our heads, it is hard for people to break free of that kind of circular thinking. But that doesn't mean it's impossible, says Petersen.

Perception is everything. A sudden trigger, for example rising U.S. wages, could start an inflationary spiral.

Mental image

Maybe rising interest rates will make strapped homeowners demand higher pay.

But young peoplehave never experiencedmassive inflation, Petersen says. It would take a lot to shake them out of that non-inflationary mental image of the world.

As McGillUniversity's TomVelk reminded me last week, a long period of low interest rates may have had another perverse effect on rising prices.

While what he calls "can-of-soup inflation" normal price inflation measured by the consumer price index remains weak, low interest rates have caused an explosion in asset inflation. House prices, for instance,have gone through the roof.

While young people assume can-of-soup inflation will stay flat, until recently their perception has beenthat interestrates will stay low andhouse-priceinflation will stay high.

"A lot of young consumers don't have the resources to go out spending or investing heavily," says Petersen. "Every young person I know is either saving for a house or paying off theirhouse, so that really puts a downwardpressureon theirdemand for other consumer goods."

Folllow Don on Twitter @don_pittis

More analysis from Don Pittis