When you expect rising inflation, so you spend now instead of tomorrow, and other people know that you spent today as to avoid the expected inflation tomorrow, which induces them to spend now too, your (and their) expectations —which are now common knowledge— fulfilled themselves, regardless of their original validity. Or in short, when expectations determine realized inflation which in turn drives those same expectations, you get a positive feedback loop, an inflation expectations trap.
In the example above, the starting point was rising inflation expectations. However, the same logic applies to cases like the ECB or Bank of Japan, which faced troubles with interests rates and inflation stuck at an effective lower bound. The story goes as follows.
Too stable, too low inflation expectations?
We can trust the central bank to keep its inflation target. So we can wait to spend until tomorrow. But as a consequence the shelves are full, and the prices do not rise, which requires the central bank to stimulate by lowering rates. Which they could, weren’t they already at zero (or negative) already. In the end, inflation is lower than expected, and people trust the central bank to keep inflation low and the loop closes.
In the short term, some macroeconomic stability can be a boon for structural reforms. However, a long term stagnation and lack of shocks induces fragility. In a sense it resembles a lack of small controlled wildfires. These in turn lead to a build up of combustible material for catastrophic fires.
If the expectations trap persists for too long, you might fool yourself into a false sense of security. Some even start to live in a fortress bordering the steppes, seeing a road in construction. But when the horde strikes, they better prepared.
So much for the inflation expectations trap. Remember that forecast hold well in normal times, but normal times are seldom of interest. With that in mind, risk is highest when it is perceived as small.
