SPEECH RIKSBANK

DATE: 12 April 2024 SVERIGES RIKSBANK
SE-103 37 Stockholm

SPEAKER: First Deputy Governor Anna Breman (Brunkebergstorg 11)

VENUE: Danske Bank, Stockholm Tel +46 8 787 00 00

Fax +46 8 2105 31
registratorn@riksbank.se
www.riksbank.se

The psychology of inflation*

The rapid and sharp rise in inflation in recent years is an important reminder of
how hard high inflation hurts households and companies and how damaging it is
for the economy. High inflation has a negative impact on everyone, with the low-
est income households suffering the most.

Let me start by saying that I am very confident we will stabilise inflation at the tar-
get. Monetary policy has contributed to a significant fall in inflation. At our last
monetary policy meeting in March, my assessment was that we could probably
cut the policy rate in May or June.

An overall assessment of the outlook for inflation going forward will determine
the timing of any interest rate cut.? The inflation outlook is currently favourable.
An important question for me is how we move towards a less contractionary mon-
etary policy without jeopardising the favourable conditions for both inflation and
the real economy. An important factor in this trade-off is the expectations of
households and companies and how this affects economic decisions. There is a
significant difference, however, between companies' inflation expectations, which
have fallen markedly, and those of households, which remain at a high level.?

So today, I intend to talk about the psychology of inflation and how it affects
households and companies, focusing on the following questions:

e How have households perceived inflation so far and what affects their in-
flation expectations?

e What have we learnt from the recent fight against inflation and how can
we use it to understand inflation dynamics in the coming years?

e What does this mean for monetary policy in the near term?

2 I would like to thank Bjorn Lagerwall for excellent work on this speech, Hanna Armelius, Aino Bunge, Charlotta
Edler, Marie Hesselman, Ann-Leena Mikiver, Per Jansson and Caroline Jungner for valuable comments and Gary
Watson for translation.

2 Statistics on inflation in Sweden for March are published on the same day as the speech. This figure was not
known when the speech was finalised and is therefore not commented on. Nor is a single monthly figure decisive
for the design of monetary policy.

3 For a more detailed discussion of this and other risks, see the minutes of the last monetary policy meeting and
the Monetary Policy Report.

1 [12]

Knowledge of how we perceive inflation and form our expectations about it has
increased in recent years. Households' inflation expectations tend to be over-
looked in the monetary policy analysis, as they are often higher than measured in-
flation. However, new research shows that households' inflation expectations are
important.* Households' expectations affect consumption, investment and saving,
factors that are important for both inflation and the transmission of monetary
policy and therefore matter for monetary policy both in the short and longer
term.

My comments today are partly based on a new Economic Commentary that I have
written with my colleague at the Riksbank, Bjorn Lagerwall, Senior Adviser in the
Monetary Policy Department. It discusses the role of psychological factors in mon-
etary policy more generally.> Today I will focus on inflation.

Why low and stable inflation is so important

The former chairs of the Federal Reserve, Paul Volcker and Alan Greenspan, have
defined price stability as a condition in which inflation does not influence eco-
nomic decisions, and that the public does not need to distinguish between nomi-
nal and real amounts.° Households thinking in nominal terms and ignoring infla-
tion in their economic decisions is normally referred to as 'money illusion'.? One
point of having price stability as an objective for monetary policy could therefore
be that the consequences of money illusion need not be so great. In recent years,
however, several central banks have highlighted that inflation plays a greater role
in economic decisions when it is high.®

Figure 1 shows inflation from the 1970s to the present day. The figure clearly
shows that high inflation also tends to mean that it varies significantly. Average in-
flation over the period 1970-1992 was just over 8 per cent, while the standard de-
viation, i.e. the average variation around its mean value, was almost 3 percentage
points. Since 1995, when the inflation target came into effect, inflation has aver-
aged just below the 2 per cent target, with a standard deviation of around 1.5 per-
centage points.

However, inflation may vary more in the future than it has done in the decades
prior to the recent upswing. Some obvious reasons for this are the risk of more
frequent supply disruptions due to a changed geopolitical situation, climate
change and -- related to this - the transition to a fossil-free economy.

If inflation starts to fluctuate significantly in the future, it will pose challenges for
monetary policy. First, it creates greater differences between how different

4 See Brandao-Marques et al. (2024) and, D'Acunto and Weber (2024).

5 See Breman and Lagerwall (2024).

© Greenspan expressed it as "...households and businesses need not factor expectations of changes in the aver-
age level of prices into their decisions" and Paul Volcker as "...'stability' would imply that decision-making should
be able to proceed on the basis that 'real' and 'nominal' values are substantially the same over the planning
horizon". See the description by Wynne (2008).

7 Money illusion is discussed further in the Economic Commentary by Breman and Lagerwall (2024).

® See for example Nagel (2022), Bayarmagnai (2023), Bracha and Tang (2022), Braitsch and Mitchell (2022) and
Norges Bank (2023).

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households perceive inflation. Second, the gap may widen between how central
banks communicate about inflation and how it is perceived by the public.°

To act quickly and effectively if inflation starts to rise again, we need, among
other things, to start using new data. However, access to more statistics is not
enough. We also need to understand better the dynamics of inflation expecta-
tions and how they affect the risk of a significant and rapid increase in inflation.
There is much to learn from the inflationary upswing of recent years and new re-
search in this area.

Inflation expectations in focus

Figure 2 shows different measures of inflation expectations in Sweden for house-
holds, companies and market participants. The measures also show their inflation
expectations over different time horizons. Some interesting patterns emerge:

e Long-term inflation expectations have remained close to 2 per cent during
the period of high inflation, regardless of the measurement method. This
shows that confidence in the inflation target is high.

e Short-term inflation expectations, i.e. one year ahead, are clearly corre-
lated with the actual development of inflation.

e Households tend to expect inflation to be higher than what market partic-
ipants expect and what actually happens.

Inflation expectations have traditionally featured prominently in central bank
analyses and communication. As inflation rose sharply in recent years, there was
renewed interest in how those expectations are formed. Two of the questions dis-
cussed are:

e whose expectations matter most for monetary policy: those of house-
holds, companies or market participants?

e do rising inflation expectations have a stimulating or contractionary effect
on the real economy?

Recently, there has also been considerable new research investigating these im-
portant issues.?° I interpret the overall results roughly as follows:

e It is important to look at the expectations of all agents in the economy.
Companies are important because they set prices, while market partici-
pants are important for price-setting in financial markets. Households' ex-
pectations affect their consumption decisions and thus economic activity -
and ultimately the ability of businesses to raise prices. Both households
and companies play a central role in wage negotiations.

e According to standard macroeconomic theory, higher expected inflation
(all else equal) leads to a lower real interest rate, which increases con-
sumption. However, more recent research highlights that higher expected
inflation among households could instead lead to lower consumption,

° In a speech two years ago, I discussed the problems that can arise if the difference between how households
perceive inflation and how we at the Riksbank communicate about it becomes too great. See Breman (2022).
10 See, for example, Campos et al. (2022), Coibon et al. (2023), Weber et al. (2022) and Adrian (2023).

3 [12]

RIKSBANK

which is explained by higher inflation being associated with a declining
standard of living.*?

My overall conclusion is that the inflation expectations of all agents are important
and should be taken into account, but we need to look more at household expec-
tations than we have done in the past. Households sometimes tend to be ignored,
as their expectations often overestimate actual inflation. The expectations of fi-
nancial market participants are sometimes emphasised more, as they tend to be
more accurate. However, this is not necessarily true during periods of major
change, such as in recent years.'? Recent research also suggests that households'
expectations in general should be given more weight in the analysis of inflation
and hence in the design of monetary policy.'?

How we perceive inflation drives our expectations

Households' perception of inflation may differ from their 'objective' measured in-
flation rate."4 This is because, in practice, households are neither able to monitor
price developments of all product categories nor know the weight of the catego-
ries in their consumption baskets. Various studies have shown that households
tend to attach importance to certain factors when they form their view of infla-
tion:

e prices that rise more than those that fall
e prices that change considerably
e prices of goods and services that households buy frequently.

In the wake of the pandemic and Russia's illegal invasion of Ukraine, food and en-
ergy prices rose particularly rapidly. These are essential items for all households,

as well as frequently purchased ones. Figure 3 shows price developments for the

entire consumption basket in the CPIF together with energy and food prices. The

sharp fluctuations in energy and food prices are clearly visible.

Let me now offer a possible interpretation of households' perceptions and expec-
tations of inflation presented in Figure 2. Firstly, we can understand that they rose
more and to higher levels than official CPI statistics have shown in recent years, as
households attached great importance to prices that increased relatively quickly,
such as food and energy. And the overall high level of households' perceptions
and expectations of inflation can be explained by the fact that they attach more
importance to rising prices than falling ones.

One might then ask why the perceived and expected inflation among Swedish
households has not fallen more, given that energy prices are now falling and food
prices are increasing at a much slower pace than before. A psychological explana-
tion, which I have already mentioned, is that households tend to ignore falling
prices, such as the price of energy, and instead pay attention to rising prices.
There are items in the consumption basket that are still rising unusually rapidly,

11 See, for example, Weber et al. (2022) and Stancheva ((2024).

?2 See, for example, Reis (2022 and 2023).

33 See, for example, D'Acunto et al. (2023) and Brandao-Marques et al. (2024)

74 I will return to the difference between measured and perceived inflation rates later.

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RIKSBANK

such as rents and housing association fees. This can result in households' percep-
tion of inflation remaining relatively high.

Another possible psychological explanation is that households compare with a
specific price level when forming a view of inflation. There is support for this in
the so-called prospect theory, which assumes that we perceive the value of an as-
set depending on how it relates to a reference.> One hypothesis is then that
households do not necessarily compare the prices of, for example, energy and
food with the same prices one year ago, but perhaps at some other point in time,
such as before the start of the inflationary upswing (see Figure 4). If the price level
of certain goods remains high according to the reference households use, they
may interpret this as inflation still being high.

The overall conclusion is that households' perceptions of inflation and inflation ex-
pectations are influenced by a range of factors, and these can differ significantly
from the official measures of inflation that normally guide monetary policy. A fur-
ther complicating factor is that different households are affected differently by in-
flation.

Differences in objective and subjective inflation

Inflation in official measures should reflect the increase in the cost of living for an
average household, but in practice, there are large differences in the consumption
basket in different households.

Figure 5 shows an estimate of how the 'objective' measured inflation rate may
differ. It shows three types of households that SCB categorises as follows: the
family with children, the student and the retired couple.*® In a speech a couple of
years ago, I discussed these types of households in more detail." The point I want
to make here is simple: Different households have different preferences and
needs; they therefore do not consume exactly the same things.

It is clear that the measured inflation of a typical family with children rose even
more sharply and to a higher level than the official CPI statistics show (see Figure
5). And it reflects a greater weight in their basket on energy and food, which rose
rapidly at the start of the inflationary upswing. The student's measured inflation
showed a slight lag in relation to official CPI inflation, but on the other hand, it
eventually rose to a higher level. The retired couple in this example escaped the
rise in inflation comparatively lightly, as their measured inflation rose later and to
a lower level than official CPI inflation. Currently, measured inflation for the family
with children and the retired couple is close to official CPI inflation, while the stu-
dent's inflation is slightly higher.

In reality, the differences in measured inflation can be much greater than for the
typical households here. For example, there can be major differences between

15 See Breman and Lagerwall (2024) for a longer discussion of prospect theory and its link to monetary policy.

46 See Statistics Sweden (2022). One difference is that SCB calls the younger single household 'the single person'
instead of 'the student'.

17 See Breman (2022).

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households depending on whether they live in a detached house with direct elec-
tric heating and a variable electricity price or in rented accommodation where
electricity is included in the rent and the electricity price is also affected by where
in the country the household lives.

I want to emphasise two conclusions from this that are important for monetary
policy. First: When inflation rises, the differences between households' actual in-
flation rates tend to widen, as the example of typical households illustrated. Now
that inflation is falling, this difference is narrowing, as shown in Figure 5. Low and
stable inflation thus also facilitates well-functioning wage formation, as it is easier
to use a common benchmark when actual inflation does not differ too much be-
tween different households.

Second: In addition to the 'objective' measured inflation rate, the perception of
inflation can differ between groups in society. We saw earlier that actual inflation
in the economy as a whole differs from households' perceived and expected infla-
tion. Exactly the same differences can occur 'at the micro level' for individual
households. The goods and services they pay attention to and purchase fre-
quently - and which shape their perception of inflation - may differ from what is
reflected in their actual consumption basket. Another interesting reason why per-
ceptions of inflation may differ relates to the literature on the importance of ex-
perience.*® Individuals who have experienced dramatic economic events are af-
fected by them for a long time afterwards. This also applies to episodes of high in-
flation.'® If we apply these insights to our typical households, the recent high infla-
tion would have affected the retired couple differently to the student. The retired
couple has a clear memory of the last period of high inflation, in the late 1980s
and early 1990s, while the student has never experienced such a period before.

This brings me to the last area today: households' actual inflation, their perceived
inflation and how their expectations can influence companies' pricing behaviour.

Household expectations and companies' pricing

Households appear to be more accepting of price increases stemming from rising
costs rather than higher demand. The explanation is strikingly simple - they see
fairness in companies raising their prices when it costs them more to produce. In
comparison, however, studies have shown that it is perceived as unfair, for exam-
ple, to increase the price of soft drinks when the weather is unexpectedly sunny,
or to increase the price of snow shovels after a snowstorm." This can have impli-
cations for companies' pricing behaviour.

With the rise in inflation in 2021-2022, companies' pricing behaviour changed
markedly from previous historical patterns. In many sectors, companies began to
pass on much or all of the cost increase to consumers."! This may have been possi-

28 For an overview, see Malmendier (2021).

19 See Salle et al (2024).

20 See, for example, Kahneman et al. (1986) and Eyster et al. (2021).
21 See National Institute of Economic Research (2023).

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RIKSBANK

ble because households found it easier to accept price increases under the pre-
vailing conditions. In the Riksbank's business survey in spring 2022, companies

stated that they "have never seen customers accept price increases so easily".?2

As with households, there are large differences between companies and how they
are affected by rising costs. Many have been hit hard by inflation in recent years
and are struggling to survive. Others have gained higher profit margins, such as
export companies that have benefited from a weak krona or some companies in
the food industry.23

Looking ahead, the pricing behaviour of companies will be central to monetary
policy. So their inflation expectations are important. An important point I want to
make, however, is that households' expectations also play a role in companies'
pricing behaviour, as they affect the acceptability of price increases.

Concluding thoughts

In Sweden, we experienced nearly 30 years of low and stable inflation. This means
that younger generations had no memory of high inflation. However, this has
changed with the recent surge in inflation, when sharply rising prices suddenly be-
came part of everyday life for broad sections of society. Research suggests that
the experience of high inflation affects economic agents for a long time.

Monetary policy has contributed to inflation falling towards the target. In Sweden,
well-anchored long-term inflation expectations have been an important part of
this development. It has created a stable foundation for wage formation that
clearly reduced the risk of a wage-price spiral. At the same time, as inflation in-
creased, we saw that short-term inflation expectations rose sharply and changed
companies' pricing behaviour. This highlights how important it is for us to under-
stand better both households' inflation expectations and companies' pricing be-
haviour in order to analyse and forecast inflation developments.

One uncertainty factor I have mentioned today is that households' perceived in-
flation and inflation expectations are still at a high level. As I have discussed, there
is new research that can help explain this. However, I believe that households' in-
flation expectations will also fall in the future as price increases slow down fur-
ther.

My overall assessment is therefore that the conditions are favourable for making
monetary policy less restrictive in the near future. It is positive that we now see
that inflation has fallen from high levels, and that the inflation outlook is favoura-
ble. 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 prepared-
ness to adjust the policy rate as we gradually work out which rate level is compati-
ble with sustainably low and stable inflation.

22 See Sveriges Riksbank (2022).
23 See National Institute of Economic Research (2023).

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ERIGES

BY
RIKSBANK

Today I have highlighted some of the research on psychological factors in behav-
ioural economics that are linked to inflation. Behavioural economics can be a
good complement to standard macroeconomic models to increase our under-
standing of both macroeconomic relationships and the development of inflation.
The trend towards macro models with 'heterogeneous agents', i.e. different types
of households, is also a welcome addition to monetary policy analysis. With new
empirical research on how households perceive inflation and form their inflation
expectations, we can better understand and manage the challenges facing mone-
tary policy in a turbulent world.

References

Adrian, T. (2023), "The Role of Inflation Expectations in Monetary Policy", speech
published on 15 May, IMF.

Bayarmagnai, G. (2023), "Rational inattention to inflation among New Zealand
households", Analytical Notes, Reserve Bank of New Zealand.

Bracha, A. and J. Tang (2022), "Inflation Levels and (In)Attention", Research De-

partment Working Papers, Federal Reserve Bank of Boston.

Braitsch, H. and J. Mitchell (2022), "A New Measure of Consumers' (In)Attention
to Inflation", Economic Commentary 22, Federal Reserve Bank of Cleveland.

Brandao-Marques, L., Gelos, G., Hofman, D., Otten, J., Kaur Pasricha, G. and Z..

Strauss (2024), "Household expectations help predict inflation", VOXEU Column,
26 January.

Breman, Anna (2022), "Inflation and monetary policy in the shadow of war",
speech published on 23 March, Sveriges Riksbank.

Breman, A. and B. Lagerwall (2024), "Monetary policy and behavioural econom-
ics", Economic Commentaries no. 6, Sveriges Riksbank.

Campos, C., McMain, M. and M. Pedemonte (2022), "Understanding Which Prices
Affect Inflation Expectations", Economic Commentary, Federal Reserve Bank of
Cleveland.

Coibion, O., D. Georgarakos, Y. Gorodnichenko and M. van Rooij (2023), "How
Does Consumption Respond to News about Inflation? Field Evidence from a Ran-

domised Control Trial", American Economic Journal: Macroeconomics.

D'Acunto, F. and M. Weber (2023), "Why Survey-Based Subjective Expectations
are Meaningful and Important", NBER Working paper 32199.

Eyster, E., Madarasz, K., and P. Michaillat (2021), "Pricing Under Fairness Con-
cerns", Journal of the European Economic Association, pp. 1853-1898.

Kahneman, D., Knetsch, J.L and R. Thaler (1986), "Fairness as a Constraint on
Profit Seeking: Entitlements in the Market", American Economic Review, pp. 728-
741.

8 [12]

National Institute of Economic Research (2023), "Price setting by Swedish compa-
nies in 2023", special study. In Swedish only.

Malmendier, U. (2021), "Experience Effects in Finance: Foundations, Applications,
and Future Directions", Review of Finance, pp. 1339-1363.

Nagel, J. (2022), "The long shadow of high inflation", speech published on 18 No-
vember.

Norges Bank (2023), "Inflation expectations in a period of high inflation", article in
Monetary Policy Report 4.

Reis, R. (2022), "Expected Inflation in the Euro Area: Measurement and Policy Re-
sponses", CEPR Discussion Paper.

Reis, R. (2023), "Four Mistakes in the Use of Measures of Expected Inflation", AEA
Papers and Proceedings.

Salle I., Gorodnichenko, Y. and O. Coibion (2024), "Lifetime Memories of Inflation:
Evidence from Surveys and the Lab", Voxeu Column, 2 February.

Statistics Sweden (2022), "Personal inflation is affected by what is consumed", ar-
ticle on the Swedish economy. In Swedish only.

Stancheva, S. 2024 "Why do We Dislike Inflation?", BPEA Conference Draft,
Spring.

Sveriges Riksbank (2022), Business Survey, February.

Weber, M., D'Acunto, F., Gorodnichenko, Y. and O.. Coibion (2022), "The Subjec-
tive Inflation Expectations of Households and Firms: Measurement, Determinants,
and Implications", Journal of Economic Perspectives, pp. 157-184.

Wynne, M.A. (2008),"How Should Central Banks Define Price Stability?", Working
Paper No. 8, Federal Reserve Bank of Dallas.

RIGES

SVERIGES
RIKSBANK

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Figures

Diagram 1. CPIF
Annual percentage change

16

12 7
8 J
4 4

Mean: 1.9
8 SD: 1.6 7
4b J
1970 1980 1990 2000 2010 2020 2030

Note. Red dashed lines refer to the mean value for the periods 1970-1992 and 1995-2024.

Sources: Statistics Sweden and the Riksbank.

Diagram 2. Inflation expectations and households' perceived inflation

Per cent
24

20
16

12

2017 2018 2019 2020 2021 2022 2023 2024
- Households, percieved inflation, now -- Prospera, 1 year -~ Market-based exp.
- Households, 1 year - Prospera, 2 years
~-- Companies, 1 year ~~ Prospera, 5 years
Note. Prospera refers to money market participants. Households refer to mean values exclud-
ing outliers.

Sources: Kantar Prospera, Bloomberg, National Institute of Economic Research and the Riks-
bank.

10 [12]

Diagram 3. CPIF and sub-groups

Annual percentage change

60

40

20

2010 2012 2014

43.1%
2022-06

2016 2018

i]
S
N
ee
i)
4

8.08%
2023-07

2020 2022 2024 2026

- CPIF - Energy -~ Food -- Goods - Services

Source: Statistics Sweden.

Diagram 4. CPIF and sub-groups

Index, 2010-01 = 100
220

180

140 -

100

60 *
2010 2013 2016

- CPIF

Source: Statistics Sweden.

2019

2022 2025

180

140

100 *

60 + =
2010 2013 2016 2019 2022 2025

- Energy -- Food -~ Goods - Services

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S
RIKSBANK

Diagram 5. Inflation for different types of households

Annual percentage change
20

16

12

2017 2018 2019 2020 2021 2022 2023 2024
- Student - Family with children - Retired couple -- CPI

Note. Refers to fictitious households where the family with children is assumed to live in a sin-
gle-family house, the student in a tenant-owned apartment and the retired couple in rented
accommodation. Calculations from Statistics Sweden's Statistical Perspective no. 12 2022.

Sources: Statistics Sweden and the Riksbank.

12 [12]