Citizens' inflation expectations, a major headache for the ECB

BarcelonaWhen it is said that something can happen, it is likely to end up happening. This expression, used to refer to self-fulfilling prophecies, is common in the economic world. Throughout history, the belief that an event will occur has precipitated events. The list of examples is long: stock market crashes, compulsive consumer purchases, or deposit withdrawals are just a few. And citizens' expectations for controlling inflation are also a factor to consider.

The European Central Bank (ECB), the highest monetary authority in the euro area and responsible for keeping the increase in prices stable around 2%, has long been aware of the importance of analyzing citizens' expectations. Since 2020, the institution has surveyed some 19,000 people monthly to gauge what the population thinks about the future evolution of prices. "The inflation levels recorded today can influence people's expectations about how prices will evolve in the future. [...] And these expectations are important, as they form the basis of people's spending, borrowing, and investment decisions," the ECB stated in a document prepared in 2021 where it comprehensively reviewed its monetary policy strategy. It added: "If expectations deviate from the central bank's inflation target, it may be difficult for the bank to steer price developments back to this target."

In a context marked by the conflict in the Middle East, an still active war in Ukraine, and aggressive tariff policies from the United States, the current diagnosis for the ECB is not very hopeful. According to the latest data published by the institution, citizens' inflation expectations are widely higher than the central bank's estimates. Europeans expect the rate to stand at 4% over the next twelve months and at 3% over the next three years, above the ECB's forecasts, which point to inflation of 2.6% and 2.1% in the respective cases.

the ECB's forecasts, which point to inflation of 2.6% and 2.1% in the respective cases.

Although the monetary authority is aware that this bias is "usual", its president, Christine Lagarde, appeared in a recent hearing before the European Parliament to warn of the "implications" of a strong mismatch between perception and real figures. The French leader attributed these expectations to three factors: the personal experiences of each individual and their shopping basket; the fact that citizens focus more on price increases than decreases, and society's financial knowledge.

"There is always more fear than is real. [...] People tend to exaggerate, and more so in a world of immediacy and lack of analysis," argues María Ángeles Ruiz-Ezpeleta, a professor at EAE Business School, who advocates for the importance of looking at underlying inflation data, which does not take into account the evolution of more volatile prices such as food or energy. Citizens' perceptions, however, are also understandable, according to academics. For example, the prices of food and fuel – two products widely present in families' shopping baskets – have risen at a higher rate than the average rate over recent months, while other products such as industrial goods – with more weight within industrial sectors – have become more expensive at a slower pace.

Financial education

For the ECB, the lack of financial education also plays a relevant role in the mismatch between real figures and perceptions. According to Albert Martí, finance professor at UPF-Barcelona School of Management, there is a "very clear gap" in financial culture in Europe. In this regard, the expert understands the calls made by Lagarde, who urged all eurozone states to dedicate more efforts to fostering a better-informed society in the economic sphere.

Martí, however, believes that the resolution of a conflict in the Middle East would completely change expectations about inflation. "In times like these, people will quickly transfer [peace in Iran] into a positive effect," he states. Despite everything, he also points out that the price of products will remain at high levels, as price increases happen much faster than decreases.

Be that as it may, experts also warn of the unpredictability of current times, with the President of the United States, Donald Trump, as the protagonist of any chapter. In just over a year in office, the world remains pending of his next crusade, although its effects on inflation could be smaller. This is what some North American media have already dubbed "Trump exhaustion syndrome", a principle by which citizens are outraged initially and then return to their usual routine, oblivious to the consequences of their actions.