High-inflation periods, such as the 2021-2023 inflation surge, pose a major challenge for European monetary policy. Marcel Garz and Benjamin Larin examine how sensational media coverage of the economy complicates the European Central Bank’s mission to achieve price stability.
Since its inception in 1998, the European Central Bank (ECB) has been working to maintain price stability in the Eurozone. During the 2021-2023 inflation surge, the ECB and many national central banks in Europe were criticised for taking too long to bring inflation back to its two per cent target. As a consequence, Europe is currently facing a cost-of-living crisis.
The role of inflation expectations
An important part of the ECB’s strategy for achieving price stability is to monitor and guide the inflation expectations of households. The reason is that households’ beliefs about future inflation affect their labour supply, consumption and saving choices. If households expect higher future inflation, they may demand higher wages and “prepone” major purchases, which in turn fuels current inflation.
Unfortunately, economists still lack a comprehensive understanding of how households form inflation expectations. While there is a consensus that most households rarely develop expectations in a strictly rational way, it remains unclear what causes them to under- or overreact to certain information. This is problematic, as the impact of monetary policy may be reduced or distorted when households form inflation expectations in unpredictable ways.
Left-digit bias
In a recent study, we investigate the role of a cognitive bias that has received little attention in monetary economics: left-digit bias, resulting from people’s tendency to focus on the leftmost digit when processing numerical information.
The implications of left-digit bias are well known in marketing and behavioural economics. Examples include 99-cent pricing, where marketers exploit this bias to increase sales; or the market for used cars, where sales prices drop discontinuously when the odometer reaches certain thresholds, such as 50,000 or 100,000 miles. However, left-digit bias has been neglected in monetary economics so far.
Data from thirty European member states and candidate countries indicate that inflation expectations of households increase disproportionately when a country’s inflation rate crosses a round-number threshold, such as five, ten, or twenty per cent. Figure 1 illustrates the occurrence of threshold events as the inflation rate increases and decreases, using Spain and Lithuania as examples. On average, expected inflation jumps by around one percentage point if current inflation surpasses such a threshold, even if the actual change in inflation is marginal.
Figure 1: Round-number threshold events in Spain (left) and Lithuania (right)
Note: Based on Eurostat’s harmonised index of consumer prices (HICP). An increasing inflation threshold event refers to a situation where the inflation rate reaches or exceeds a multiple of five per cent, whereas a decreasing inflation threshold event refers to a situation where the inflation rate falls below a multiple of five per cent.
Sensationalism in inflation-related news
A primary driver of discontinuous jumps in households’ inflation expectations are mass media. An analysis of nearly 300,000 news stories shows that media outlets in Europe change the way they report about inflation when a country’s inflation rate reaches a round-number threshold.
Rather than simply reporting the inflation rate, threshold events induce media outlets to produce headlines designed to stir up emotions, such as “Eurozone inflation sets another record, hitting 10 percent in September” or “UK food prices soar by fastest rate on record as cost of living crisis bites”.
Media researchers call these headlines sensationalistic, as the message relies on the psychology of round numbers and emphasises a record, milestone or something extraordinary. These headlines do not primarily aim to inform readers, but media outlets use them to draw attention and generate clicks.
Competition for attention online has substantially increased during recent decades. Media companies face decreasing readership and advertising revenues, which creates pressure to exaggerate, bait and sensationalise. Unfortunately, when it comes to news coverage about the economy, this reporting style produces large negative external effects.
Lessons for monetary policy
When predicting the effect of a policy measure on inflation and household expectations, it is advisable for the ECB and other central banks to account for psychological round-number effects. On average, a multiple-of-five threshold event (such as five, ten or fifteen per cent) causes a discontinuous jump in households’ expected inflation rate by one percentage point. When the inflation rate reaches a salient round number, the ECB’s policy response is likely more effective if it factors in this threshold effect.
Once the inflation rate crosses a round-number threshold, both expected and actual inflation remain at elevated levels for extended periods. Hence, it takes longer for contractionary monetary policy to reduce inflation and inflation expectations than in a world without left-digit bias and media sensationalism.
From a communication perspective, it is therefore advisable for central banks and statistics agencies to avoid presenting information about inflation framed as a “new record high” or in terms of some historical or statistical rarity. Instead, providing the plain facts can help them to reduce the effects of left-digit bias and make monetary policy more effective.
For more information, see the authors’ accompanying paper.
Note: This article gives the views of the authors, not the position of EUROPP – European Politics and Policy or the London School of Economics. Featured image credit: Mabeline72 / Shutterstock.com
