Why inflation feels higher than it is

Ulrike Malmendier is fast becoming a superstar of behavioural finance. She is one of the few academics where I make sure to read practically every paper she publishes because they tend to be relevant to investors, insightful in their conclusions and really well done in their experimental setup. Unfortunately, she probably will never win a Nobel Prize since she doesn’t create grand theories, but instead focuses on real life behaviour.

In any case, she recently published with three colleagues an investigation into how people form inflation expectations. This is extremely timely since we are once again in a phase where people are getting afraid of inflation and many people point to everyday examples of things (e.g. groceries, houses, etc.) getting more expensive as a sign that inflation is already rampant and official inflation data underestimates true inflation.

I have a lot of sympathy for these observations since it feels the same to me. But feelings are not what inflation is about. When people tell me that inflation “feels” much higher than the official numbers, there likely is some behavioural trap involved. And it seems that in the case of inflation there are two behavioural biases at work simultaneously.

First, there is all our loss aversion. It’s been established for decades that investors “feel” losses about two to three times more intensively than they “feel” gains. The regret after losing even small amounts of money is much worse than the joy from gaining the same amount. When it comes to inflation this works the same way. If we want to buy something where we know how much it “should” cost (or how much it cost the last time we bought it) and today it costs more, then we experience this higher price as a loss. Meanwhile, if it costs less today, we experience it as a gain. But this means that we react much more strongly to prices going up than to prices going down. Thus, we have a natural tendency to overestimate inflation because the emotional marker for things becoming more expensive is much stronger than for things becoming cheaper.

The second effect is that we form our expectations not by how important an event or a purchase is, but how often we do it. I have recently written about the “illusory truth effect” in the spread of conspiracy theories. In essence, it is the effect that the more often we see the same information, the more likely we are to accept it as true, even if it is not.

When it comes to inflation, we seem to do the same. We adjust our inflation expectations more to the inflation we observe in items we purchase more often, even if they cost us just a little and have no substantial impact on our personal inflation rate. That is the problem. Because the things we buy all the time are groceries and the like. And these prices swing wildly, sometimes creating much higher inflation rates than the overall average. In these times, we notice the inflation in these groceries and adjust our expectations upwards. On the other hand, when some groceries get cheaper, we don’t adjust our expectations downwards again. So we are constantly increasing our inflation expectations based on our daily purchases of food items and the like. But for most of us, food isn’t really a major part of our overall inflation basket. For a middle-class person, it accounts for somewhere between 10% and 25% of our total expenses. This effect makes inflation feel higher than it really is.