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People Can Forecast Price Rises—If Asked the Right Questions
While consumers are a little hazy about overall inflation, asking them about prices for individual categories yields more realistic forecasts.
- By
- July 15, 2024
- CBR - Economics
People are bad at predicting inflation, which is a problem for policymakers charged with managing the economy, because expectations about prices tend to be self-fulfilling.
The Federal Reserve uses a monthly survey in which its New York branch simply asks nonexperts to forecast the Consumer Price Index. But there may be a way to get a more accurate fix on where consumers really think inflation is headed, according to a six-member international research team that includes Chicago Booth’s Michael Weber.
Asking survey participants to forecast prices in 11 spending categories—rather than overall inflation―resulted in more realistic predictions, the researchers find. They conducted a two-year study involving almost 60,000 Americans. The results amount to a “proof of concept” for refining how central banks assess consumer sentiment, the researchers suggest.
Why do consumers’ inflation expectations matter? If people believe that prices will rise sharply in the near future, they are more likely to buy things sooner rather than later, which may amplify inflation. It’s a similar dynamic when workers demand higher wages because they expect prices to keep rising—but when wages rise, that drives up the cost of producing goods. Companies increase the price of those goods, and workers then demand higher wages. Economists call this a wage-price spiral.
US consumers see aggregate versus category-specific inflation differently
The overall view of inflation was much higher than predictions of inflation for specific goods and services, according to a survey that asked Americans where they thought inflation was headed in the next year.
But consumers can be wrong and send false signals rippling through the economy. “Many consumers struggle to grasp the concept of inflation; they rely on salient cues when reporting forecasts; and survey responses are vulnerable to a host of cognitive biases,” the researchers write.
While the concept of “inflation” in the aggregate can seem abstract, people may have a firmer sense of prices for specific types of goods and services, the researchers posited. To test their theory, in addition to asking about the overall CPI, they surveyed consumers about their expectations for prices of motor vehicles, recreational goods, other durable goods, food and beverages, gasoline, other nondurable goods, housing and utilities, health care, transportation, food services, and other services.
The researchers sent out questions via the Federal Reserve Bank of Cleveland’s daily survey of consumers between July 2020, when inflation was extremely low, and August 2022, when it touched a 40-year high. They asked respondents what they thought the inflation or deflation rate in each category would be over the following 12 months. They also asked whether people expected to increase or decrease their own spending in those areas and by how much.
Respondents consistently said they expected overall inflation to be higher than the combination of their category-specific forecasts would signal. In fact, estimates for aggregate inflation were higher than estimates for any individual category. There were also sharper differences in estimates for overall inflation than existed in any category, the researchers find.
The survey responses yielded additional information about how consumers’ backgrounds may play into their forecasts. For one, the primary grocery shopper in a household tended to have higher inflation expectations, and so did lesser-educated consumers and those from lower socioeconomic strata than more highly educated, higher-income respondents. Yet surveying consumers about individual components of inflation and combining the results always yields better aggregate forecasts than asking them about overall inflation, the researchers conclude.
Alexander Dietrich, Edward S. Knotek II, Kristian O. Myrseth, Robert W. Rich, Raphael Schoenle, and Michael Weber, “Greater than the Sum of Its Parts: Aggregate vs. Aggregated Inflation Expectations,” Working paper, November 2023.
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