Macro Signposts | 5 March 2024

This week, during our quarterly Cyclical Forum, I asked Anastasia Buyalskaya to guest author Macro Signposts. Dr. Buyalskaya, a behavioral science advisor to PIMCO, integrates behavioral insights and methodologies into our investment process.

Unless explicitly stated, views expressed do not constitute official PIMCO views.

How Do Consumers Perceive Inflation? Perspectives From Behavioral Finance

By Anastasia Buyalskaya, Ph.D. – advisor to PIMCO on behavioral science

Investors are having a hard time reconciling today's strong U.S. economic data – low unemployment and relatively high consumer spending – with widespread pessimism from American polling and sentiment surveys. Literature from behavioral finance, which has delved more deeply into how consumers actually perceive inflation, may help explain this conundrum – which may partly stem from individuals' tendency to overgeneralize from their own experiences, and from different (sometimes opposite) behaviors in response to inflation.

These behavioral science insights also offer insight into the macro and market phenomena of inflation expectations. Central banks, and investors, monitor indicators of inflation expectations alongside price indices: Expectations are a key input into monetary and portfolio decisions. Applying the behavioral lens across common indicators of inflation expectations, in aggregate, we may glean that actual expectations for inflation may be somewhat higher than the indicators suggest.

Understanding the dual nature of inflation
First, not all inflation is created equal: Consider prices versus wages. While we think of them as being correlated, consumers tend to associate price inflation with worse economic conditions, but wage inflation with better economic conditions (Jain, Kostyshyna, Zhang, 2022). This difference may be explained in part by the human tendency to heavily extrapolate from one's own experiences and assume that one's viewpoint is widely shared (something called the "false consensus effect").

Many consumers therefore view wage inflation as a good sign ("I'm making more money – which is probably the case for most people – so the economy must be doing well") but price increases as a bad sign ("My money doesn't go as far these days – which is probably the case for most people – so the economy must be doing less well"). This would be the case whether or not higher prices were passed through to consumers in part because the underlying cost of human capital required to produce goods and services (e.g., wages) has increased.

The impact of personal experience on inflation perception
This idea that consumer perceptions of inflation are largely based on their own direct experience also explains why some items are heavily (over)weighted in individual inflation expectations. For example, individuals may weight more frequently purchased items such as a gallon of milk more heavily than official inflation statistics do when it comes to expectations about the persistence of inflation, even though such items may be a small fraction of one's consumption basket (Cavallo, Cruces, Perez-Truglia, 2017; D'Acunto, Malmendier, Ospina, Weber, 2020).

This may be because people interact with grocery prices much more frequently than wages. Any increase in price levels, even if minor, appears particularly salient. The new price means that the consumer's reference point has changed ("I had $4.25 in mind for a gallon of milk, and now it is $5"), and they temporarily feel like they are operating in what prospect theory refers to as the "domain of losses." New reference points take time to sink in (I will need to buy milk several times before $5 is my new benchmark), and even more time if the reference point had been stable for longer (Malmendier and Nagel, 2016).

So consumer perceptions of inflation vary widely – and depend a lot on individual experiences and consumption baskets – even when economists, investors, and indeed consumers are in agreement regarding the true rate of inflation.

Diverse consumer reactions to inflation
Second, even if all consumers agree on the true level of inflation, they may respond in different – and sometimes opposite – ways. In my research, I asked individuals whether they observed any irrational behavior among their peers in response to increased inflation. Two camps stood out. The first camp was stunned by peers who became "very frugal," "were buying reduced-price items in a supermarket," and "not putting heating on" – in other words, peers who significantly decreased their spending in the short term. The second camp of respondents were shocked at how some of their peers started "stockpiling," "buying in bulk while the prices were low," and "taking out a fixed term mortgage" – in other words, peers who significantly increased their spending in the short term. Consumers may have differing views on the "right" response to higher inflation. Can both be rational?

Different types of rational behavior
On one hand, reducing spending in the short term is rational if your overall budget is already stretched and purchasing power suddenly drops further. Academic research confirms our intuition that consumers who are more financially constrained reduce their overall spending (Karlsson et al. 2004, 2005). Consumers behaving this way are most likely doing so out of necessity.

On the other hand, if you believe that inflation will remain elevated but can afford to spend a bit more today, then it may make sense to invest in high-durability items today in order to lock in prices for tomorrow (therefore consuming more in the short term). Indeed, research finds that rates of homeownership have gone up during periods of high expected inflation (Malmendier, Wellsjo, 2023), as people able to afford it seek to lock in lower mortgage rates and potentially lower prices for a necessity that is projected to become more expensive. Consumers may also seek a higher-paying job if they expect inflation to remain elevated (Hajdini, Knotek II, Leer, Pedemonte, Rich, Schoenle, 2023).

Returning to the conundrum mentioned at the outset: If a substantial portion of consumers are behaving like this second group (i.e., spending more now to lock in prices that may rise further), then perhaps the macroeconomic trends of lower unemployment and higher consumer spending are supported precisely because consumers are pessimistic about the economy, and not in spite of it.

Inflation perception and its monetary policy implications
Whether consumers, in aggregate, react to higher expected inflation by spending more or saving more has important implications for monetary policy. If the dominant effect on the macroeconomy involves consumers seeking higher pay, switching jobs, and spending more, then the countercyclical stabilization role of the central bank becomes even more crucial. In the current cycle, macro indicators of spending, housing demand, and job switching have remained elevated (albeit off their peaks), while household savings rates have stayed low – a concerning pattern that suggests the behavioral effects of higher prices and elevated inflation are still taking their toll. Assessing inflation expectations across a range of indicators suggests they are elevated, despite inflation expectations signals from consumer and business surveys remaining low – an uncomfortable fact for central banks.

Read the previous edition of Macro Signposts where we previewed the key macro themes likely to affect the outlook for the next year.

We welcome your questions about the global macro landscape. Don't hesitate to suggest themes or data for us to analyze and discuss: Please email [email protected].

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Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

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