Time to remind clients about the money illusion?

Faced with a six-month streak of CPI readings exceeding its target range, the Bank of Canada last week declared that it’s moving to end its quantitative easing program even as it maintains the current pandemic-low levels of interest rates. In other words, the bank is acknowledging that the inflation the country is seeing is not just temporary, and is starting to pare back its stimulus to hopefully avoid an overheating economy.

To be sure, finding a balance between averting runaway inflation and plunging the economy into a new recession will be a challenge for policymakers. For their part, everyday Canadians will likely be grappling with how to course-correct for inflation in financial plans – and that’s not so easy for a lot of people.

The tendency to fail to account for price changes, according to Shlomo Benartzi, professor and co-head of the behavioral decision-making group at UCLA Anderson School of Management, is called the money illusion.

“Put simply, the money illusion refers to the fact that people typically tend to think in nominal dollars—the actual amount of money spent or earned—and not real dollars, which is the purchasing power of money after taking inflation into account,” Benartzi wrote in a piece published by the Wall Street Journal.

Benartzi referred to the Rule of 72, which says you can calculate the number of years it would take for your purchasing power to be cut in half by taking 72 and dividing it by the annual inflation rate. Given the U.S. core inflation rate reading of 3.6%, for example, he said someone would expect that in 20 years, they’d only be able to buy half as much as they could with a dollar today.

Time will tell, but reality could prove to be even worse for Canadians: last month, Statistics Canada reported that annual inflation hit an 18-year record of 4.4% in September. But even knowing that stat, many Canadians may still find themselves unable to adjust appropriately because of the money illusion’s deeply ingrained influence on the human mind.

To illustrate, Benartzi cited a widely known thought exercise devised by Eldar Shafir, Peter Diamond, and Amos Tversky, which involves three people who each buy a house after receiving a $200,000 inheritance, then sell their house a year afterward. Economic conditions – specifically, rates of annual inflation – were different in each case.

One person sold his house for 23% less than the price he paid originally, another sold his for the same price he originally paid, and the last one sold his for a 23% markup. However, since the first person made the sale during a period of 25% deflation, and the third was facing 25% inflation, the first home seller was the one who turned a profit in real terms even as he lost out in nominal dollars.

To account for inflation, Benartzi advised homebuyers to consider getting a fixed-rate mortgage; as housing values tend to rise with inflation, having fixed mortgage payments means they can build equity faster. Bond investors, meanwhile, might want to consider the fact that long-term inflation expectations could hurt future coupon payments as they lose their purchasing punch, thus making even the seemingly safest long-term fixed income instruments into risky assets.

“If you fail to account for inflation in your financial plans, you’ll almost certainly feel its impact over time,” Benartzi said. “The key is to take action before you feel the pain of rising prices, because once you notice the pain it’s probably too late.”