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We expect perceived inflation to remain than double the rate of actual inflation (5.6% y/y in 2023), and structurally above the historical average of 6.8%, with persistent uncertainty over the medium term. The growing disconnect of perceived inflation is similar to that observed during the run-up to the global financial crisis (GFC) when rising asset and real estate prices pushed up overall price levels. However, there is also an important difference – the large share of households experiencing inflation to be higher for longer suggests that perceived inflation has become stickier (Figure 2). Thus, households will take longer to adjust their inflation expectations, which could impact the ECB’s capacity to keep high inflation from becoming embedded in the economy (Figure 3).

While official statistics provide a standardized framework for assessing inflation, several factors contribute to the perceived inflation being higher than the reported figures of actual inflation:

• Frequency bias: Consumers pay more attention to the change in prices for out-of-pocket purchases that occur frequently, such as convenience food and beverages, fuel and grocery errands. If these prices have increased above average, individuals tend to extrapolate a higher perceived inflation and overestimate actual inflation. Conversely, price changes of goods and services, which are purchased less frequently (such as cars and furniture) or occur automatically (via direct debits), such as rent payments, subscriptions or insurance fees, are likely to weigh less on our perceptions of the inflation rate.
• Personal consumption bias: Individuals tend to have unique consumption patterns and preferences. If the prices of the goods and services they primarily consume increase at a faster rate than the overall inflation rate, they may perceive inflation to be higher. People tend to focus more on the prices of essential items such as housing, healthcare or education, which have experienced substantial cost increases in recent years.
• Perception bias and anchoring: Psychological factors can influence how individuals interpret and remember price changes and create cognitive bias. People tend to focus on significant and/or more recent price increases or memorable instances of price inflation, which can contribute to the perception of higher inflation rates. Conversely, stable or declining prices tend not to be noticed but are included in the calculation of the average inflation rate.
• Regional and demographic variations: Inflation rates can vary across regions, cities or even neighborhoods. Official measurements rely on national or regional averages, which may not accurately reflect the situation at a micro level. Individuals residing in areas with a higher cost of living or experiencing local supply shocks may perceive inflation to be higher than what is reported nationally.
• Substitution bias: The official inflation rate is calculated based on a fixed basket of goods and services. However, as prices fluctuate, consumers often substitute their purchases for more affordable alternatives. This substitution bias is not fully accounted for in official measurements. As a result, individuals who observe substantial price increases in their preferred goods or services may perceive higher inflation rates.
• Quality adjustments: The quality of goods and services can change over time, making direct price comparisons difficult. Official statistics attempt to adjust for quality improvements, but these adjustments may not always capture the true impact on individual experiences. If consumers perceive a decline in quality or reduction in features while prices remain constant or increase, they may perceive inflation to be higher.
• Limitations of official inflation measures: Official inflation measurements focus on consumer goods and services and often exclude asset prices such as the cost of shelter. Since real estate prices and rents have increased significantly in recent years, individuals may perceive inflation to be higher due to rising costs that actual inflation does not capture by design. In addition, inflation is not immediately felt by individuals as it takes time for price changes to trickle down through supply chains. By the time the effects of inflation become apparent, the official measurements may not fully reflect the current situation. This lag between price changes and official reporting can contribute to the perception of higher inflation rates.

The gap between perceived and actual inflation matters for insurance companies. It can significantly impact risk assessments, profitability and customer behavior. Insurers rely on accurate inflation data to calculate premiums and manage their liabilities effectively. If perceived inflation deviates significantly from actual inflation, it can lead to a mispricing of insurance products and inadequate reserves. Therefore, insurers need to closely monitor the gap between perceived and actual inflation to mitigate risks and ensure sound financial management.

It also matters for the ECB. The gap between perceived and actual inflation serves as a vital barometer of public sentiment and consumer expectations. When people perceive inflation to be higher than the official figures, it can influence their behavior, leading to adjustments in consumption, investment decisions and savings habits. A deeper understanding and acknowledgment of the large difference between perceived and actual inflation informs better decisions on the evolving policy rate path. Our projection of a large gap until the end of next year (Figure 1) confirms our above-consensus expectation that the ECB will maintain its restrictive monetary stance until September, with three more 25bps rate hikes at the next three meetings of the Governing Council until September to reach a terminal rate of 4.0% for ECB deposits (which is the effective policy rate).

Reconciling perceived and actual inflation requires proactive measures to enhance communication, accuracy and transparency. Some possible measures include:

• Financial literacy and “authenticity”: Educating the public about how inflation is measured and its impact on daily lives can help align perceptions with official measurements. This could also be combined with efforts aimed at developing consumer price indices that reflect the specific consumption patterns of different demographic groups or regions. This can bridge the gap between the generic basket of goods used in official measurements and individual experiences.
• Enhanced data collection and transparent reporting: Statistical agencies at the national and European levels can improve data-collection methods to capture real-time price changes accurately to reduce latency and incompleteness. Incorporating technological advancements, such as big data analytics and online price monitoring, can enhance the accuracy and timeliness of inflation measurements. This also includes more surveys to gauge consumer perceptions of inflation, identify discrepancies and understand the reasons behind the gaps. Some national statistical agencies should also provide clear and accessible explanations of their inflation measurement methodologies, including the factors considered, sample sizes and frequency of updates.

Inflation rates vary across the Eurozone. While inflation rates have fallen over the recent months to slightly more than 6% in May, they vary a lot across countries – from 2.8% in Greece to more than 11.0% in the Baltics as of May. Germany is not only geographically in the middle of Europe but also in the middle of the pack at 6.1%, while Austria struggles with 8.8%. However, Switzerland – one of the two countries’ largest trading partners, albeit not a member of the EU nor the Eurozone – records very low inflation (2.2%).

What explains the gap? Geographic proximity to Russia, dependence on energy and food imports, government intervention to lower individual prices and currency strength. In Germany, all these factors conspire to keep inflation high. The embargo on cheap energy imports from Russia caused the energy bill to rise sharply at the onset of the war in Ukraine. The German government counteracted this with expensive price breaks and subsidies. In the Eurozone overall, a weak euro has increased inflation by raising the cost of dollar-denominated commodities such as oil or gas. More recently, however, Germany has benefited from the stronger euro due to the ECB's interest rate hikes. Producer and wholesale prices have thus fallen since fall 2022, which has eased inflation with a lag (Figure 4).