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POLITICS: PennAve

Americans keep getting inflation wrong --- here's why that matters

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Photo - Not surprisingly, survey respondents who based their guesses on recent inflation outperformed those who simply looked at the price of milk. (Photo: iStock)
Not surprisingly, survey respondents who based their guesses on recent inflation outperformed those who simply looked at the price of milk. (Photo: iStock)
Politics,PennAve,Joseph Lawler,Economy,Inflation

Americans keep overestimating inflation, and it could be coloring their views on the economy.

Many Americans are convinced that the value of the dollar is dropping faster than it is, a disconnect that has widened in recent years.

The outsize concern about inflation could be leading many investors and lawmakers into faulty decisions.

Experts who study inflation perceptions blame a lack of financial literacy for the phenomenon.

Over the past 10 years, inflation has averaged roughly 2.4 percent annually, a relatively low rate. But the median respondent in the University of Michigan's consumer survey projected roughly 3.2 percent annual inflation over that time.

And the average projection — which is influenced by the wildly high guesses of some respondents — has been 4 percent.

Those don't sound like very big differences, but in the context of inflation, they are. If U.S. inflation had averaged 4 percent over the past 10 years, real economic output growth would have been close to zero. In reality, the economy expanded by over 15 percent.

Psychologist Wandi Bruine de Bruin was engaged by the Federal Reserve Bank of New York to study why consumers overestimate inflation. She found that consumers are misled by price fluctuations on small, recurring purchases such as gasoline.

She and other researchers asked consumers to think aloud as they answered the question about inflation expectations used in the University of Michigan survey.

They found that people who start out answering the question by noting past inflation generally have lower estimates of future inflation, closer to reality.

The people who predicted much higher inflation, on the other hand, tended to begin their thought processes by noting specific prices they had recently paid for goods or services. Of course, the price changes that are “most likely to come to mind are extreme and are increases,” de Bruin explained.



The finding held across people’s differences in income, education, and race.

But it’s not just that those people have faulty information about prices based on one or two goods they track closely. It appears that their entire thought process is flawed.

That’s what Mary Burke, a researcher at the Federal Reserve Bank of Boston, found when she conducted her own experiments.


BurkeBurke and other researchers asked subjects to predict inflation in the real world and in simulated economies based on historical data. They then gave the subjects a choice of which information to use in formulating their guesses.

Some of the choices were highly relevant broad indicators, such as a chart of actual headline inflation in the past three years. Others were just prices of a single item, such as milk or gas.

“We were able to look at not only how well they could do in making a forecast, but also what information they wanted to look at,” said Burke.

Not surprisingly, those who based their guesses on recent inflation outperformed those who simply looked at the price of milk.

“Literacy helps you in two ways — knowing which info to use, and how to use it,” Burke concluded.

That might be why inflation misperceptions persist even among informed consumers who encounter lots of price changes in their everyday lives.

But why do they tend to err toward thinking inflation is higher than it is, rather than lower?

One reason is that many of the recurring purchases people make, such as for groceries or gas, increase in price more frequently.

The relative price increases in such nondurable goods are offset by price decreases in bigger-ticket durable goods such as cars, computers, or appliances, which benefit from technological improvement over time.



So while you might be annoyed that milk costs slightly more than it did last week, you may not realize that your computer is significantly cheaper and more powerful than the one you bought several years ago.

“People don’t register price decreases because it doesn’t annoy you,” explains Burke, “or because you buy it less frequently, so you’re not noticing.”

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