Households tend to overestimate past inflation and to expect future inflation to be above the ECB’s target inflation. This raises concerns about the anchoring of inflation expectations. In general, the upward bias in inflation perceptions is a mostly harmless phenomenon. But the current energy price shock linked to the war in Iran may lead households to revise their inflation expectations upward more quickly because the inflation surge of 2021-22 remains fresh in memory.
The ECB’s primary mandate is to maintain price stability in the euro area. Fulfilling this mandate depends not only on keeping actual inflation under control, but also on how inflation developments are perceived and anticipated. Changes in inflation expectations can affect household spending, saving, and wage bargaining.
Bias mostly limited to households
To achieve its medium-term target of 2 percent, the ECB therefore needs to ensure that inflation expectations of households, firms, and financial market participants remain firmly anchored around that objective. Even as euro area inflation has returned close to the ECB’s 2 percent target, survey data shows that many households still report significantly higher expected inflation. This phenomenon is limited to households, while firms, financial market participants and forecasters inflation expectations remain in line with realized inflation rates.
This upward bias in perceptions by households may raise concerns about the anchoring of inflation expectations and the effectiveness of monetary policy. The influence of recent inflation experiences will fade, but the upward bias is a general phenomenon that will likely persist. So far, it has been mostly harmless.
Drivers of upward bias in inflation expectations
While the upward bias in households’ inflation expectations varies over time, it is generally present in the data and can be observed in many other countries outside of Europe as well — even at times when inflation is low. A large body of academic research has studied how households form their inflation expectations and how this can lead to persistent upward biases.
A central finding of the academic literature is that households’ understanding of inflation, its causes and consequences, and their attention to inflation is often limited. Households tend to focus on frequently purchased goods, overweigh large or salient price increases, selectively recall extreme changes, and focus on sources of information that are not representative for overall price developments.
Effects on consumer behavior are mixed and often modest
While perceptions matter for economic decisions, the evidence suggests that the effects on actual behavior are mixed and often modest. Households reporting inflation expectations of 10 percent over the next 12 months do not behave and consume in ways consistent with such high expectations. Rather, behavioral responses appear to be driven mainly by changes in expectations over time. These changes do matter — but there is no evidence that the upward biases in their level are important for the conduct of monetary policy.
Recent experiences matter and are a risk factor today
The inflation surge of 2022–2023 in the euro area was historically large and highly salient. Sharp increases in energy and food prices were visible and frequent, making them memorable for households. Moreover, a high degree of media coverage increased attention. Economic research shows that such experiences can shape perceptions for some time, even after inflation moderates. We currently do not expect the upward bias to grow significantly weaker in the next few years. So far, long-term household expectations have remained close to the ECB's target. However, should the energy shock in Europe today translate into large and persistent inflation, the risk of de-anchoring of household’s inflation expectations is greater than in normal times because the inflation surge of 2021-22 remains fresh in households’ memory.
Limited but important policy implications
The general upward bias in inflation perceptions highlights the importance of clear and accessible communication. Inflation is a complex concept, and households naturally focus on prices they encounter frequently. ECB communication should take subjective perspectives and understanding of inflation seriously as a starting point. Explaining how inflation is measured and why individual price changes can differ from overall inflation can help narrow perception gaps over time and reduce credibility risks to the ECB.
Overall, the divergence between perceived and actual inflation does not currently point to a fundamental problem for monetary policy. Rather, it reflects a general phenomenon, visible even at times when inflation is low. Nonetheless, a joint political effort should be undertaken to further broaden the public’s knowledge of the concept of inflation and how monetary policy operates. The current inflationary pressure makes this issue even more timely.
More Analysis can be found in SAFE White Paper No. 117
Claudia Schaffranka is Co-Head of Policy Center at SAFE.
Peter Andre is Professor for Behavioral Finance at SAFE.
Michael Weber is Professor of Finance at the Purdue University Daniels School of Business and Research Affiliate at SAFE.
Blog entries represent the authors’ personal opinion and do not necessarily reflect the views of the Leibniz Institute for Financial Research SAFE or its staff.
