Photographer: Scott McIntyre/Bloomberg

Consumers Are Always Wrong About Inflation. But They’re Worth Listening To

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Ask anyone old enough to remember the introduction of the euro, and there’s a good chance they’ll tell you prices doubled as a consequence. That’s not even close to reality – inflation was 2.2 percent in 2002 and hovered around that level for years – but it probably won’t sway your interlocutor.

A study by the European Central Bank – based on European Commission data – shows that consumers as a whole always overestimate price growth. Yet, there’s more to the skewed perception than the misplaced grumblings of shoppers from Rome to Dublin. Their over-estimation has significant implications for politicians and central bankers.

Between 2004 and and mid-2015, the mean perceived inflation rate in the euro area was 9.5 percent, which was “considerably above” the actual average inflation rate of 1.8 percent, the research shows. For the European Union, perceived inflation was 9.8 percent versus an actual figure of 2 percent.

The extent of the misjudgment varied according to education, gender, and how well the economy is doing – and the divergence between nations is striking.

Despite recurrent scare stories in the media about runaway prices, Germans tend to overestimate inflation less than most of their European peers, while in countries where inflation is higher (e.g. Bulgaria, Latvia or Romania) or where the economy hasn’t fared well (e.g. Italy or Greece), the perception of inflation is much more detached from reality. Swedes, Finns, Danes, French and Belgians are the most accurate, especially when it comes to predicting inflation.

According to the study, “consumers are more prone to overestimate inflation during recession periods.”

Also, since the single currency’s inception, when the divergence between perception and reality was at its maximum, things have been slowly improving – possibly with the help of near-zero inflation in the last few years.

And policy makers may take comfort in the fact that expected future inflation has always been below perceived current inflation, signaling confidence in central banks’ ability to keep prices broadly in check.

As the chart shows, though, even as they overestimate the level of the inflation rate, consumers have a pretty clear idea of whether it is accelerating or slowing.

Finally, the study also shows that the more educated people are and the more money they have, the closer their perception of inflation is to reality. And young people and women always think price growth is stronger than men and older people do.

But do these perceptions matter? Yes, if one doesn’t take them at face value.

First of all, the variation across countries and social levels may tell us something about the way the economy works. As the study puts it, “the reasons for such divergences are not well understood and may be worth investigating in depth in future follow-up work.”

Moreover, the study found “a significant – though quantitatively small – positive relationship between expected inflation and consumers’ willingness to spend for the euro area as a whole,” as low inflation expectations may weaken consumer spending.

Additionally, the gap between perceived and measured inflation can be significantly reduced with a proper statistical treatment and a careful phrasing of the survey question, as already happens for similar polls in the U.S. and the U.K.

Further research may yield insights on central banks’ credibility and on the relationship between consumers’ inflation expectations and the overall demand of the activity – a key factor officials look at when setting policy. 

As to why people believe the price of your cup of coffee is constantly spiraling out of control, there isn’t a clear answer yet. 

“There are many possible different explanations for why people perceive inflation as higher than it actually is,” said Heinz Dieden, on behalf of the study’s nine authors. “These include quality improvements – which are factored into official prices statistics but might not be accounted for by consumer – and possibly different reference baskets – consumers may think of more frequent out of pocket purchase, whereas official consumer prices are based on a reference basket of goods reflecting a wider range of goods and services.”

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