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How Consumers Think About Inflation |
A deeper understanding of how consumers think about the economy
would help policymakers control inflation
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With inflation rising to levels unseen in decades, households across the
world are asking themselves how much more they can expect to pay for
gasoline, groceries, and other necessities. Their answers may help them make
important personal financial decisions. Should they go ahead and buy that
new refrigerator, rather than wait until later and risk seeing the price go
up? Should they ask their boss for a raise to make up for the loss of
purchasing power?
The answers wont affect just individual households but the economy as a
whole. The reason: central bankers and academic economists view inflation
partly as a self-fulfilling prophecy. If consumers believe prices will rise
at a faster pace, they may behave in waysbuying a refrigerator or asking
for a raisethat will fuel more inflation. More money chasing a fixed number
of refrigerators will drive up their price, and more people asking for a
raise will prompt employers to mark up the prices of goods or services they
sell to make up for higher labor costs. Federal Reserve Chairman Jerome
Powell expressed that concern at a recent press conference, when he
announced a half-point increase in the Feds key interest rate: We cant
allow a wage-price spiral to happen, he said. And we cant allow inflation
expectations to become unanchored. Its just something that we cant allow
to happen.
Powells statement explains why policymakers carefully monitor households
and firms inflation expectations, measured through regular surveys, at
different time horizons. In particular, increased forecasts for inflation in
three to five years signal that expectations are becoming unmoored and that
an interest rate increase may be needed to keep inflation under control.
This also explains why central banks try to shape the publics expectations
of future developments by explaining their current and future policies.
Indeed, the success of policymakers actions crucially relies on their
ability to convey the intended effect to households and steer their
expectations accordingly.
Coffee, gasoline
All this raises an important question for academics and policymakers alike:
How well do we understand households expectations? Over the past decade, a
large body of behavioral economics research has dug deep into this question.
The main findings are that households hold very disparate views on inflation
and tend to perceive it as higher and more persistent than it usually is.
Consumers also tend to disagree on the outlook for inflation more than
experts do, they change their view less often, and they often rely on a few
key products they consume regularlysuch as coffee and gasolineto
extrapolate changes in the overall cost of living. Furthermore, individual
expectations are strongly correlated with demographic characteristics
including sex, age, education, and political orientation. For instance,
women and people with less education or lower incomes tend to expect higher
inflation. Finally, past experiencessuch as living through the Great
Depression or the 1970s Organization of the Petroleum Exporting Countries
(OPEC) oil embargo, which drove inflation sharply higher, can strongly shape
peoples perceptions of inflation for the rest of their lives (Malmendier
and Nagel 2016; Weber and others, forthcoming; DAcunto, Malmendier, and
Weber, forthcoming).
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When households think of specific
shock propagation mechanisms, they often come up with very
different channels than experts.
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While these results characterize the richness and complexity of households
expectations, they do not quite break down how those expectations are
formed. When nonexperts read news about monetary and fiscal policy or
economic events, how do they factor that information into their expectations
for inflation and other key indicators? Is it safe to assume, for effective
policymaking and for theoretical models, that laypeople form expectations in
the same way as experts? Knowing the answers to these questions would help
policymakers better guide consumers expectations regarding the effects of
their actions.
In a recent paper, my coauthors and I set out to search for answers (Andre
and others 2022). We conducted surveys to measure peoples beliefs about the
effects of economic shocks on unemployment and inflation. From 2019 to 2021,
we collected answers from samples of 6,500 US households broadly
representative of the population. Separately, over the same period, we
surveyed 1,500 experts, including staff at central banks and international
financial institutions, professors and PhD students, and financial sector
economists. For the samples of the survey collected during the COVID-19
pandemic, we adjusted the questionnaire to ensure that the respondents
expectations referred to how the economy functions in normal times rather
than during the exceptional circumstances of the pandemic.
Hypothetical shocks
We used the survey to shed light on how people think about the way the
economy worksor in the language of economists, their subjective models.
We asked respondents to consider four hypothetical shocks to the US economy:
a sharp increase in crude oil prices as a result of falling world supply, a
rise in income taxes, a federal government spending increase, and a rise in
the Federal Reserves target interest rate. These shocks are widely studied
in macroeconomics but are also conceptually understandable by nonexperts. To
make sure that all the respondents based their answers on the same
information, we provided current figures for the rates of inflation and
unemployment and asked them to give their forecasts for the two variables
over the following year. We then provided news about one of the four
hypothetical shocks and asked them to make new predictions for inflation and
unemployment.
Their responses showed that beliefs about the effects of economic shocks
were widely dispersed, with large differences within our samples of
households and experts and between the two groups. In some cases, households
and experts even disagreed on whether a particular shock had a positive or
negative impact on inflation and unemployment. Most strikingly, households
on average believed that a rise in the central banks policy interest rate
and a rise in income taxes would increase inflation, contrary to predictions
of a decrease by experts and many textbook models.
In the second part of the survey, we investigated the origins of
disagreement between experts and households and within the two groups. Part
of the disagreement seems to arise because respondents think the shocks work
through different transmission channelsin particular, demand- versus
supply-side mechanisms. Using a set of multiple-choice questions and open
text boxes, we asked respondents to describe what they were thinking when
they made their predictions. We found that these associations explained a
substantial part of the differences in forecasts. Unsurprisingly, experts
were most likely to rely on their technical knowledge, using frameworks
taken from their everyday toolkits and often making direct reference to
theoretical models or empirical studies. By contrast, households drew on a
broader range of approaches in making their predictions. They were more
likely to rely on personal experiences, be influenced by political views, or
simply guess how a given shock might affect the economy.
Moreover, when households think of specific shock propagation mechanisms,
they often come up with very different channels than experts. This in turn
partly explains why their predictions for some shocks differ so markedly
from those of experts. For instance, households more often thought about the
impact of higher interest rates on firms costs of borrowing capital, which
are passed on to consumers via higher prices. On the other hand, experts
mostly considered the canonical demand-side channel, which predicts a
decline in inflation in response to higher interest rates as consumers spend
less and save more.
Contextual cues
Are these results bad news for central bankers? If the general public
interprets an interest rate hike as a harbinger of higher inflation, might
central banks find it more difficult to succeed at keeping inflation at bay?
One final result from our exercise points to effective communication of
policy actions as a solution. Contextual cues can shape which propagation
channels individuals think of and thereby which forecasts they make. We saw
that households that were prompted to think about demand-side channels
before making their forecasts were more likely to predict an effect of
monetary policy shocks in line with that of experts.
Encouragingly, while central bankers have long been aware of the power of
their carefully crafted statements to guide market expectations, it seems
they are now focusing more on making their communication accessible to a
wider audience. For instance, Gardt and others (2021) show that, as part of
a broader strategy to expand the reach of their message, in recent years the
European Central Bank has built a presence across social media platforms and
has used simpler language in speeches and monetary policy statements.
The results of our study also provide some empirical guidance in a different
but related direction. Canonical macroeconomic models crucially hinge on the
assumption of rational expectations, according to which households base
their individual decisionson how much to save, consume, and workon
expectations about the uncertain future state of the economy. These
expectations in turn are consistent with the way the economy eventually
evolves. The assumption does not mean that households have perfect knowledge
of the future. But it does imply that if households see the central bank
raising interest rates unexpectedly, and they believe this will lower
inflation, their subsequent actions will ultimately lead to a decline in
inflation. While this approach to modeling expectations has often been
criticized as too strict or unrealistic, deciding the appropriate way to
depart from it is not straightforward. To be meaningful, any departure from
this pillar of modern macroeconomics must realistically reflect how
households actually form expectations. Our study thus provides a preliminary
direction for macroeconomic models to incorporate behavioral aspects of
households expectations that are grounded in empirical evidence.
A growing research effortspearheaded by prominent academics in the
fieldaims to use insights from behavioral economics to embed behavioral
features of the way households form expectations in macroeconomic models and
depart from classic rational expectations assumptions. This field, known as
behavioral macroeconomics, is expanding fast but faces some significant
challenges. It is math-intensive, which may limit its immediate use in
everyday policy work. Moreover, it relies crucially on empirical evidence of
how households reason about the macroeconomy and form expectations, which
behavioral economists can solidly build only through numerous and careful
studies. However, it has the potential to fundamentally shape both
theoretical macroeconomics and real-world policymaking in the years to come,
and it will most likely find a key role for communication in influencing
expectations.
By: Carlo Pizzinelli |
