Salient Price Changes, Inflation Expectations, and Household Behavior

Abstract

How do households form their inflation expectations? We show the price changes individual consumers observe while shopping are a key determinant of their expectation for overall inflation. We use individual non-durable consumption choices in the Nielsen Homescan Panel to construct household-level measures of perceived inflation. We find perceived price changes help explain inflation expectations across individuals and within individuals over time. The frequency of purchases not the expenditure share determines the importance of perceived price changes for inflation expectations. The effect is stronger for individuals that shop less frequently, and hence are more likely exposed to several and larger price changes in their typical shopping trip. The effect is also stronger for individuals whose uncertainty about inflation is higher and who self report to not rely on the media when forming expectations. Because individual inflation expectations shape economic decisions, central banks' focus on core inflation instead of the heterogeneous price changes in households' non-durable bundles might lead to systematic policy mistakes.