Price perception and inflation rate: what is real ?

Jan Schmidt Director, DG ECFIN

European Commission

Brussels, 14 March 2005

OVERVIEW OF PRESENTATION

• EMU as a stability-oriented regime

• Consumer perceptions of inflation and the euro changeover

• Explanation of the discrepancy

• Conclusions

EMU as a stability-oriented regime

• The euro is part of a change of regime whose purpose is to ensure better macroeconomic conditions for sustainable growth and job creation (Art. 2 of the Treaty)

• One key element is the price stability objective of the ECB

• The ECB has been successful: HICP inflation has been around 2 percent since 1999

EMU as a stability-oriented regime

• This is a great achievement compared to earlier periods (see chart)

• Inflationary expectations are well-contained, i.e. close to the 2 percent level

CPI Inflation rates (annual % change)

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Private consumption price deflator percentage change p.a.Dotted line = ECB inflation ceiling

Consumer perceptions of inflation and the

euro changeover (observations)

• The euro cash changeover brought changes in prices, but the overall impact was limited

• A comparison between actual and perceived inflation shows a growing discrepancy after the changeover

• The perceived inflationary impact raised many questions and resulted in a public debate (such as the “teuro” in Germany)

Consumers’ perceptions of inflation and the euro changeover (measurement)

• The ‘perceptions of inflation’ is an index built upon qualitative surveys asking some 20.000 consumers about 15 issues among which how they perceive inflation developments

• By translating this qualitative information into a quantitative indicator, an index is built and can be compared to the observed HICP (Chart)

• Before the euro changeover, both indexes were closely related; since the changeover of January 2002, a strong disconnection has been observed

Euro area : inflation perceptions(Consumer Survey Balances)

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Source: Commission services

Chart B1.

Euro area : inflation perceptions and expectations(Consumer Survey Balances)

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Inflation Perceptions

Inflation Expectations

Source: Commission services

Chart B1.

Consumer perceptions of inflation and the euro changeover (results)

• The comparison of both indexes shows that consumers have significantly overestimated inflation, perceiving it around probably the double of what the HICP effectively registered

• According to Eurostat ex-post calculations the changeover would be responsible of only a marginal impact on the inflation: between 0.1 and 0.3 percentage points of the total annual inflation rate of 2.3% in 2002

• This means that most of the 2002 inflation rate is explained by other factors including increases in energy and food prices, tobacco tax increases, etc. not linked to the euro and affecting also non-euro Member States

Consumer perceptions of inflation and the euro changeover (the new Member state

dimension)

• Perceptions of a substantial impact of the euro changeover on inflation have been widespread over euro-area Member states

• In the new Member states, over two-thirds of people questioned have expressed concerns over the inflationary impact

• This justifies a search for explanations

Explanation of the discrepancy (‘small item’

inflation) Both consumption theory and empirical work suggest

that consumers form their inflation perception on the basis of some small but frequently purchased items which are subject to an increased number of price changes

This means that consumers assess inflation with higher “subjective weights” attached to frequent purchases, thus their assessment diverges from the HICP

Explanation of the discrepancy (the ‘small

item’ basket) While it is a fact that some categories of goods and services

(haircuts, coffee, newspapers) registered higher price rises, their small weights in the total index explain why these rises were nearly compensated by other price development in major categories.

This behaviour seems due to lower competition in these sectors, allowing sellers for taking profit of the changeover.

Eurostat constructed a sub-index grouping a selection of some frequently purchased items. The index followed closely the perceptions of inflation by consumers (Chart 3)

Conclusions Consumer misperceptions are based upon the fact that

some psychologically important categories of goods and services registered relatively strong price increases during the changeover

This experience points to the need to make the changeover transparent to the public

A strong information campaign would help. Specific efforts are also needed to develop confidence building measures and to enforce correct price conversion, such as code of conduct between consumers’ and retailers’ associations, dual price display, monitoring of prices