Quantified perceived and Expected Inflation in the Euro Area European Commission Directorate General Economic and Financial Affairs Quantified perceived and Expected Inflation in the Euro Area How Incentives Improve Consumers Inflation Forecasts Presentation by Staffan LINDÉN Joint EC-OECD Workshop on International Developments of Business and Consumer Tendency Surveys 14-15 November 2005 European Commission 2005

Purpose Investigate whether differences in incentives to collect information can explain the gap between the perceived and expected inflation rates, and the official rate. Inflation is in general perceived and expected to be higher than the official rate Present the data European Commission 2005

Outline Costly information and how strong incentives to form expectations improve projections Data Stylised facts from the qualitative data Comparison of qualitative and quantitative data Time series properties Perceived and expected inflation when there are incentives to collect information Conclusions European Commission 2005

Main message Incentives to collect information on inflation induce respondents to produce inflation rates that are closer to the official rate. It is important to ask questions that are relevant, and that respondents have the information necessary to give informed answers. The answers to the quantitative questions behave in a similar way as the qualitative. The dataset is becoming unique, almost 400,000 observations just for the euro area European Commission 2005

The role of costly information Hypothesis: incentives to collect information on inflation induce respondents to produce inflation rates that are closer to the official rate. There is a trade-off between informational efficiency and the incentives to acquire information. It is costly to collect and process information If respondents have no incentives to do so, they will not inform themselves. This leads to noise in the indicators. European Commission 2005

Three survey questions inducing people to collect information of inflation Q13: How likely are you to buy a car? Q14: Are you planning to buy or build a home? Q15: How likely are you to spend any large sum of money on home improvements? It is assumed that these activities gives respondents different incentives to obtain costly information. European Commission 2005

The Balance Statistic for perceived and 12 months lagged expected inflation European Commission 2005

Stylised facts regarding the qualitative data There are structural shifts in perceptions and expectations after 1 January 2002. There is a de-linkage between perceived inflation and actual inflation. Perceived inflation is over stated after January 2002. Perceptions have been converging towards the actual inflation rate. Expectations are more in line with the actual inflation than perceptions after January 2002. European Commission 2005

Perceived and expected inflation in the euro area European Commission 2005

Stylised facts continued Inflation perceptions and expectations fall as income increases. Inflation perceptions and expectations fall as education increases. Perceived inflation seems to increase with age, and expected inflation is hump-shaped. Women perceive and expect higher inflation than men. European Commission 2005

Quantitative perceived and 12 month lagged expected inflation rates European Commission 2005

What are the findings from the comparison Quantitative data gives the same results as the qualitative. The euro area data replicates the results obtained using other similar datasets. There has been a convergence process going on. European Commission 2005

Perceived and expected inflation when incentive to obtain information is different The incentives are assumed to come from the purchase of a car, a house, or spending a large sum of money on home improvement Figures to compare with Overall perceived inflation is 11.6% Overall expected inflation is 6.1% Official HICP rate of inflation is 2.2% European Commission 2005

Perceived inflation rates depending on likelihood to buy or invest European Commission 2005

Expected inflation rates depending on likelihood to buy or invest European Commission 2005

Results from incentive induced inflation perceptions and expectations The more likely respondents are to buy a car, a house, or make home improvements, the closer the reported inflation rate is to the official rate. Perceptions: respondents that are ‘fairly likely’ are 0.9 p.p. to 2.4 p.p. below the ‘not at all likely’ Expectations: respondents that are ‘fairly likely’ are 0.9 p.p. below the ‘not at all likely’ The exceptions are for those respondents that are ‘very likely’ to do so European Commission 2005

Adjusting for sample size The relatively high inflation rates for the ‘very likely’ are caused by outliers in the German data. Small samples are over represented in the euro area aggregate. Two combined solutions Re-group the data into two categories When calculating the euro area inflation rates, adjust for both country and sample size. European Commission 2005

Perceived inflation rates depending on likelihood to buy or invest – regrouped and weighted by size European Commission 2005

Expected inflation rates depending on likelihood to buy or invest – regrouped and weighted by size European Commission 2005

The levels are still above the official rates, but… Results from incentive induced inflation perceptions and expectations – regrouped and weighted by size The more likely respondents are to buy a car, a house, or make home improvements, the closer the reported inflation rate is to the official rate. Perceptions: respondents answering ‘likely’ are 1.5 p.p. to 2.2 p.p. below the ‘not likely’ Expectations: respondents answering ‘likely’ are 1 p.p. to 1.8 p.p. below the ‘not likely’ The levels are still above the official rates, but… …for expectations the distance is almost halved. European Commission 2005

Conclusions The quantitative data is of a high quality. It behaves well according to the benchmark. Incentives to obtain information on inflation improves the survey responses. The expectations decline by as much as 1.8 p.p. (the overall rate falls from 6.1% to 4.3%, which still is above the official rate of 2.2%). The gap to the official rate is thus partly explained European Commission 2005

Conclusions continued It is important to ask questions that are relevant, and that respondents have the information necessary to give informed answers. It can be useful to “cut” the data in different ways to improve the survey results. European Commission 2005

Relevance of the questions For most questions in the harmonised questionnaires respondents have the information readily available. For the questions on price developments, less so. Different consumption baskets Macro-variable that requires a lot of information to forecast The more detailed the question, the more information is necessary European Commission 2005

Quantifying qualitative data Three different methods are used The Balance Statistic The Carlson-Parkin Method The probability approach The Anderson Method The regression approach European Commission 2005

Perceived inflation quantified by using the Carlson-Parkin and the Anderson methods European Commission 2005

Expected inflation lagged 12 months, quantified by using the Carlson-Parkin and the Anderson methods European Commission 2005

Perceived and 12 month lagged expected inflation - the Anderson method adjusted for the structural break European Commission 2005

Correlations between perceived and expected inflation, and actual inflation European Commission 2005

Comparison with other national datasets The above mentioned stylised facts are present in similar datasets from the US and Sweden. For income, education, and gender the results are the same. It differs for age. European Commission 2005

Correlations between quantitative, qualitative, and actual inflation European Commission 2005