How inflation expectations affect households
If you think prices will rise, then there is a good chance they will. A look into the world of inflation expectations and why they play such a major role in our economy.
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To save or to spend?
Inflation expectations refer to the ideas or predictions people have about future price changes. If you think everything will become more expensive next year, your inflation expectations are positive. If you think everything will become cheaper, then your inflation expectations are negative: you don’t expect inflation, but rather deflation.
These expectations influence how you handle money. Let’s say you expect everything to become more expensive next year. In that case you would probably prefer to buy that new bike or fridge now instead of next year. Moreover, when inflation is high, saving can be less attractive, as the inflation rate may well be higher than the interest rate on your savings account.
However, if everyone expects prices to rise next year and starts buying more now and saving less, demand for products and services will go up. When supply cannot keep up with demand, inflation actually increases.
Companies also sometimes factor inflation expectations into their prices. If companies expect to pay their suppliers more next year, they will often factor that into their own prices now. They are especially likely to do so if they are unable to adjust their prices often.
Inflation seems a simple concept: the rate at which prices rise on average. However, a complex story is concealed behind that single percentage. And there are many differences between households. Not everyone feels the effects of inflation in the same way. From your daily shopping to your energy bill, the impact of inflation depends on your income, spending patterns and financial resilience. In a series of three articles, we look at how inflation affects households differently. In previous articles, we looked at how differences in spending habits, wages, assets and debt lead to a different impact of inflation. In this third article, we look at the influence of inflation expectations on actual inflation.
Wage negotiations
Expected inflation may also affect how workers or unions negotiate wage increases. In practice, wage increases are often linked to past inflation, but expectations for the future can also be of influence. Suppose you and your coworkers think that all prices will rise 4% next year instead of 1%. In that case you will be more likely to demand a higher salary during wage negotiations.
Stable expectations useful for financial planning
Stable inflation expectations are essential to ensure a healthy economy. Indeed, this makes financial planning easier, reducing the need for consumers and businesses to constantly adjust their behaviour in response to changes in the inflation rate. This is one reason why euro area central banks work to keep inflation stable around the 2% target.
They also pay close attention to what people expect. For instance, they use questionnaires to survey households, businesses and other market participants about their inflation expectations. If these inflation expectations are too high, people will adjust their behaviour accordingly, which could actually cause inflation to rise, in turn driving even higher inflation expectations. It then becomes difficult for central banks to use their interest rate policy to control inflation and keep it stable at the 2% target.
Different sources of information
Research shows that households base their inflation expectations mainly on price changes of products they buy every day, such as groceries. Regular expenses that we have to pay on the spot stand out more than, say, direct debits for mobile phone plans or sports club memberships. Also, high and rising prices grab our attention more than prices that fall or stay the same. Different households spend their money on different things, meaning they will also see different price developments and their inflation expectations may also differ.
Media reports, conversations with friends and acquaintances, or previous experiences also play a role. When rising prices come up as a topic of conversation more often, you are more likely to adjust your expectations accordingly. People who follow economic news often base their expectations on different information than people who pay less attention to such reports. Experiences from the past also play a role. Older people who have experienced periods of high inflation more often in the past may have different inflation expectations than younger people, who may never have experienced an inflation spike.
Knowledge and trust
When people trust central banks to keep inflation under control, their expectations tend to remain more stable, research reveals. And stable expectations, in turn, help to prevent inflation from deviating from the 2% target in the longer term. This is why we at DNB do our best to communicate clearly and transparently on how inflation is evolving and what the ECB and the other European central banks are doing to keep it under control.
Research shows that knowledge is an important factor for trust. Knowledge about the economy, inflation and future economic policies helps people to make better-informed decisions. We endeavour to raise awareness about financial topics, the economy and what we do as a central bank, for example by contributing to Money Week in schools and communicating about inflation and the economy on our website and in the media. You are also welcome to learn more by visiting us in De Nieuwe Schatkamer.