Anna Breman: New research on the psychology of inflation valuable when addressing monetary policy challenges

“Households’ inflation expectations tend to be overlooked in the monetary policy analysis, as they are often higher than measured inflation. However, new research shows that households’ inflation expectations are important. Households’ expectations affect consumption, investment and saving, factors that are important both for inflation and the transmission of monetary policy and therefore matter for monetary policy both in the short and longer term”, Breman explains.

Research in behavioural economics highlights the tendency of households to attach more importance to rising prices than to falling ones, and of their perception of inflation being more affected by prices of goods they frequently buy, such as energy and food, than by other prices. These prices rose particularly rapidly after the pandemic and Russia's illegal invasion of Ukraine. Behavioural economics research also emphasises that households' perception of fairness can influence companies' pricing. Households seem to be more willing to accept price increases caused by higher costs than higher demand. This may have allowed companies to increase their consumer prices more in recent years, further fuelling inflation.

The research also indicates that dramatic events such as the rapid and sharp rise in inflation in recent years can affect people's economic decisions over a long period of time.

"Now that an entire generation has experienced a period of high inflation for the first time, will households and businesses act differently in the future?" Breman asks.

There is also a risk that inflation peaks will become more frequent, in which case household perceptions may have an even greater impact.

“It is positive that inflation has fallen from high levels and that the inflation outlook is favourable. At our last monetary policy meeting in March, my assessment was that the policy rate could probably be cut in May or June. However, a smooth return to sustainably low and stable inflation should not be taken for granted. Monetary policy therefore needs to be characterised by a learning approach, with preparedness to adjust the policy rate as we gradually work out which rate level is compatible with sustainably low and stable inflation.

“With new research on how households perceive inflation and form their inflation expectations, we can better understand and address the challenges facing monetary policy in a turbulent world,” she concludes.