Establishing a more holistic understanding of inflation expectations via the supermarket

The problem

Inflation expectations – how consumers predict future price increases – plays a crucial role in shaping economic behaviour, from the level of individual households to national economies. Understanding how these expectations are formed is key for effective economic management and policy design. Yet little is known about how consumers are influenced by the cross-section of supermarket price changes – that is, prices changing for many different products at the same time.

The research

Filling this gap, Associate Professor Sam Tsiaplias has analysed inflation expectations of 85 thousand consumers compared with unique data on actual price changes at Australian supermarkets, finding peoples’ inflation expectations are excessively influenced by certain elements in supermarket prices (such as an increase in a particular item) rather than considering the overall picture of how prices are changing across various products and services. The published research also reveals sharp price increases (known as the ‘right tail’ of price changes) play a large role in how people predict future inflation – tending to predict higher inflation as a result. This effect is especially strong for lower income households.

The impact

The research contributes novel evidence to the literature: that the right tail of supermarket price changes (largely ignored to date) is a material factor in explaining inflation expectations, and, more generally, on the economic implications of cognitive limitations.  Since the beliefs people form around inflation feed into critical aspects of the economy – such as consumption, monetary policy and interest rates – these insights and a more holistic understanding of inflation expectations have a range of implications. From banks to policy makers, the research could facilitate more effective economic management and is already gaining traction; the research, for example, recently cited in a speech by Sarah Hunter, Assistant Governor at the RBA: Inflation Expectations – Why They Matter and How They Are Formed.

Department: Melbourne Institute 
Area: Consumer expectations, inflation