In May 2017, the Consumer Confidence Index (CCI) sustains its upward trend, increasing by 3.6 points compared to April (moving from -25.6 to -21.9). Its first component, the Present Situation Index, rises by 3.4 points (from -32.8 to -29.4), and its second component, the Expectations Index, goes up by 4.2 points (from -18.5 to -14.3).
In April, we explained the greater appetite for consumption by two factors: the new opportunity to travel visa-free to the countries of the European Union and the stabilization of the lari exchange rate (the latter of the two factors is closely linked to expected inflation, as a lari devaluation directly translates into higher prices).
In May, it appears that the stabilization of the lari exchange rate becomes an even more salient factor for consumer confidence. The data show that people have recently revised their inflation expectations: in April, 10.5% of the respondents expected the prices to increase, while in May, only 3.2% of respondents still hold this opinion. What are the implications of this expectation shock for the consumption climate?
DOES INFLATION DISCOURAGE OR STIMULATE CONSUMPTION?
The connection between expected inflation and consumption is less straightforward than one might think. On the one hand, inflation comes with an economic and societal cost. In his 1956 paper “The Welfare Cost of Inflationary Finance”, published in the Journal of Political Economy, Martin J. Bailey showed that inflation has essentially the same distortionary effect as a sales tax. His famous argument is the following: for consuming, one needs cash (or a checking account), on which no interest is paid, so that inflation constantly reduces the value of money held in these forms. Consumption is therefore indirectly “taxed” through inflation, as holding the money needed for consumption is costly. As it is well established that almost every tax, particularly a sales tax, has distortionary effects reducing welfare, Bailey argues that inflation has the same detrimental consequences. Essentially, the existence of inflation incentivizes people to consume less as they would otherwise do. In addition, inflation requires frequent adjustment of prices, which may come with so-called “menu costs”, and inflation is associated with higher uncertainty about future prices, reducing the willingness of entrepreneurs to invest. All of this suggests that the overall connection between inflation and consumption is negative.
However, Bailey’s article was written at a time when the Keynesian school of thought was about to become dominant in economics. Keynes tended to be more positive about inflation. His ideas formed the basis for an influential theoretical construct, the so-called Phillips Curve, which posits that higher inflation goes in parallel with higher growth (which in turn is correlated with lower unemployment). Keynes argues along the following line: inflation only takes place when producers reach their production capacity limits, as otherwise, they will respond to higher demand through increased output. Therefore, inflation is correlated with greater utilization of production capacities, which means that with inflation, more is produced than without inflation.
While for a long time, the empirical evidence was not clear, there is now a consensus that the correlation described by the Phillips Curve is not supported by data. The theoretical argument advanced against the Philips Curve is that producers will not wait until they reach their capacity limits before increasing prices – in an inflationary environment, they will anticipate future inflation and raise their prices instantaneously, independent of the utilization of their production facilities.
Yet, even if one agrees that in the long run, inflation does not foster economic growth, there are short-run effects that point in the other direction. Firstly, inflation has a redistributive effect from the lender to the borrower. In an inflationary environment, you may be more inclined to take a consumer credit and buy a car, because the money you will pay back later has less purchasing power than the money you got today. Secondly, inflation makes saving less profitable and in this way discourages it.
Of course, one may argue that if the inflation is anticipated by all economic agents, the interest rate for loans and savings was constantly adjusted and there were no effects of this kind, yet we know that in reality, this is not happening. In phases of hyperinflation, for example in Germany in 1923, people immediately spent any money they had earned, not even waiting one day. Money that was received in the morning had lost a considerable share of its value in the evening, so consumption took place whenever income was incurred.
The fact that expected inflation enters the CCI negatively is therefore a potential flaw of the CCI methodology. If the CCI is supposed to elicit the short-run consumption climate, as one would expect for an index that is computed on a monthly basis, inflation should enter the CCI positively.
WHEN BAD EXPECTATIONS DO NOT COME TRUE
When it comes to inflation, as well as some other indicators, it seems that the bad expectations people held in March and April did once again not materialize. Also in May, economic doomsday did not occur.
It is always difficult for a person to cope with a situation in which cherished beliefs were refuted, and psychologists have argued that such discrepancies are major sources of psychological discomfort, causing people to take drastic steps to re-establish consistency. According to the theory of Cognitive Dissonance, developed by the psychologist Leon Festinger, there are essentially two ways how one can deal with a discrepancy between one’s beliefs and the empirical facts: one can either revise one’s beliefs or deny reality (yet one cannot remain in a state of inconsistency between what one believes and what the facts suggest). In his 1956 book “When Prophecy Fails”, Festinger and his co-authors describe the rise of a bizarre UFO cult in the United States whose followers believed that the world was going to end on the 21st of December, 1954. When this prediction does not materialize, some people leave the sect, but others become even firmer believers in the cult (those who deny reality). Another similar example is the Christian fringe group of Jehovah's Witnesses, which has a long and rich history of failed predictions (mostly related to starting of Armageddon and the return of Jesus). Yet despite the fact that plenty of times their predictions have turned out wrong, more than eight million Jehovah's Witnesses still adhere to this interpretation of Christianity, known for their restless proselytization efforts (which may be a strategy to cope with the many failed predictions – already Festinger observed that those who remained in the UFO sect feverishly tried to recruit new believers).
Georgian consumers, on the other hand, chose the rational way of dealing with their economic cognitive dissonance. When their negative expectations about inflation and other economic parameters did not realize, they revised their expectations instead of denying reality, which could for example have taken the form of conspiracy theories (“the inflation numbers are faked”). Due to this rational reaction, the recent stabilization of the lari is finally also reflected in consumer confidence.
Interestingly, not only Georgian consumers turned towards optimism but also businessmen. The Georgian Business Confidence Index (BCI), also to be found on the homepage of the ISET Policy Institute, improved in the second quarter of 2017 even more than the consumer confidence index!