Economists are paying more attention to our inflation fears

Ask people what they think will happen to inflation in future, and you will get some pretty funky answers. On average they predict too much price growth, and also disagree wildly among themselves. This is awkward for economists, who would often rather assume away such complications. Some have responded with denial, doubting that household surveys of inflation are useful at all.

In the context of painfully high price growth, over the past few years there has been a wave of inflation research. It has confirmed that people do have biases, but that their views should not be dismissed. One recent review summarised it tactfully as follows: “These people are the subjects that economists aim to study: maybe they are idiots, but they are our idiots.”

What exactly do we know? Well, most of us don’t carry calculators around in our heads. We are stung more by price increases than we are soothed by discounts, and we pay attention to the prices of things that we buy more often, not what most burdens our budgets.

More specifically, we are swayed by prices of particular products, though in the recent inflationary episode Paula Patzelt and Ricardo Reis of the London School of Economics warn against overstating this effect. Yes, our expectations are sensitive to energy prices, but they estimate their big increase only explains around a sixth of the recent rise in average European inflation expectations.

Another recent finding confirms that when inflation is low, people tend to ignore it. (Shockingly, most see perusing statistical websites as a chore.) But as it rises, so does the value of being informed, along with the accuracy of perceptions. The bad news for policymakers trying to keep expectations anchored is that those of better informed people become harder to shape.

On average this century, the poorest third of surveyed Americans have expected inflation one year ahead to be around a percentage point higher than the richest third. Some of the difference could well be real, if for example those on lower incomes have recently seen a higher share of their budget eaten up by punishingly priced groceries. Those who are already economising will also find it harder to “trade down” to buy cheaper stuff.

But part may be biases in people’s memories. In unpublished research, Weber and Francesco D’Acunto of Georgetown University compare what people say they paid for milk with what they actually paid, using scanner data. Reassuringly, people get current prices about right. But when it comes to prices a year ago, between a quarter and a third of them (particularly those on lower incomes) systematically underestimate what they paid, and so overestimate inflation.

American partisanship may also be a factor. Carola Binder of the University of Texas at Austin, Rupal Kamdar of Indiana University and Jane Ryngaert of the University of Notre-Dame find that Democrats’ expectations of inflation one year out stayed pretty well anchored between 2020 and 2023. Meanwhile, Republicans’ expectations went on a much wilder ride, responding more vigorously to news; at the start of this year they were still more than a percentage point higher.

Do these biases matter? There is a (horrifyingly) thin but growing base of evidence showing how inflation expectations translate to spending and work decisions. And in some cases, what might seems like bias can actually deliver useful information, and help to predict episodes of runaway price growth.

On top of some earlier historical examples including in Brazil, Turkey, South Africa and the US in the 1970s, Reis found that beginning in 2021 a group of Americans started to expect higher inflation than the average, which turned out to be prophetic. An IMF working paper also finds that in America greater disagreement about expected price growth can predict higher inflation one year later.

Given that, parts of the distribution of US inflation expectations look a little worrying. Something odd is still happening to people’s expectations for five years’ time, whereby the upper tail of estimates remains higher than it was before the pandemic, mostly driven by those on low incomes.

Federal Reserve chair Jay Powell seems pretty relaxed, reporting on June 12 that inflation expectations “appear to be well anchored”. So is Reis, who says the evidence that surveyed expectations so far out are reliable is pretty tentative. That said, he adds that investors also seem to be pricing in higher inflation over a five-year horizon, so perhaps confidence in central banks over the long haul has been damaged by the recent episode. Which wouldn’t be so idiotic at all.

soumaya.keynes@ft.com

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