Inflation is a Persistent ‘Beast’, but It Seems to Finally Be Settling Down

The subjective experience in economic behavior is often crucial for decisions regarding buying or selling, which is why perceived inflation impacts demand. Even if goods are not actually more expensive, it is expected that the consumer will refrain from purchasing or at least postpone the decision until conditions approach the desired ones. In Croatia, according to a European Commission survey, the rate of perceived inflation is significantly higher than the real one, yet a decline in consumption is not occurring. We posed questions about the phenomenon of perceived inflation and its impact on the economy to Dr. Petar Sorić from the Faculty of Economics in Zagreb.

Does the subjective perceived inflation rate have a historical record in Croatia, and what is its recent trend?

Since May 2005, the European Commission has been conducting a monthly survey on consumer attitudes regarding relevant micro and macroeconomic phenomena as part of the so-called consumer confidence surveys. For instance, consumer opinions are surveyed regarding their household’s financial situation, the general economic situation in the country, and among other things, inflation. One of the questions in the survey is a quantitative assessment by respondents of the perceived inflation rate over the past 12 months. The answers to this question are not publicly disclosed; the data owner is the IPSOS agency, but the data has been made available to the Croatian National Bank (HNB), so a recent analysis by the HNB shows that perceived inflation is usually several percentage points higher than actual inflation. This type of bias is not characteristic only of Croatia but also of other European countries, as is known from related literature. The gap between actual and perceived inflation is often somewhat more pronounced during stronger inflationary pressures or larger crises. For example, perceived inflation was several times higher than actual during the inflationary shock, especially in 2022 and 2023. However, it is to be assumed that it will return to some usual bias as inflation stabilizes.

How does perceived inflation affect citizens from different income categories?

Consumer confidence surveys provide insight into separate data by socio-demographic groups. The perceived inflation of economically vulnerable groups is usually higher than that of wealthier groups. For instance, lower income brackets perceive inflation to be much higher than higher income brackets. The same applies to lower-educated consumers compared to those with a university education, older citizens compared to younger ones, and so on. Each household essentially has its own inflation rate depending on how its consumption basket is structured. If someone spends most of their budget on food, it is expected that their perception of inflation will be heavily influenced by food price movements. Similarly, if someone spends a lot on technology, they may subjectively assign that category of goods a slightly higher weight than official statistics do in calculating inflation.

What are the implications of significantly elevated subjective inflation rates on economic movements?

Hypothetically, if perceived inflation were persistently several times higher than actual inflation over a longer period, it would mean that the central bank lacks credibility since its primary goal is to keep inflation stable, and inflation is measured by the harmonized consumer price index. If citizens do not perceive that index as valid, then the central bank is doing futile work because it conducts monetary policy on a target variable that is irrelevant to citizens. I believe this is not the case in Croatia and that one cannot speak of a lack of credibility of the central bank in that context.

Moreover, perceived inflation is a very important indicator as it determines many types of economic decisions. If a critical mass of consumers truly believes that inflation is such a problem, they would punish retailers by reducing consumption. Of course, this is not possible for essential goods, but it is certainly possible for many others. For instance, for a research project, I calculated that the price elasticity of demand coefficient for alcohol, tobacco, and medicines (Eurostat COICOP category: alcohol, tobacco, and narcotics) in Croatia is -0.0047. This means that our demand for these products hardly reacts to price changes at all. By the way, this is the lowest elasticity coefficient in that category in the entire EU. A recent case of store boycotts also showed that consumers do not want to give up the consumption standard they are accustomed to, even in the case of an inflationary shock.

So, for now, does the gap between real and perceived inflation not affect consumption?

In theory, it should, but the trend of rising real consumption that we are witnessing suggests otherwise. Economic agents do not make decisions based on official statistics but based on their own perception of those same data. The concept of the perfectly informed homo economicus is a myth. In today’s world, where we consume thousands of products and services daily, making an informed decision about purchasing each individual item means thoroughly researching the prices of that item in all stores that offer it, regardless of how much that item costs and how much share it has in the consumption basket. Of course, no one does that; instead, consumers largely generate their own perceptions of inflation subjectively based on information from the media, social networks, and similar sources.

If the price of a non-essential good is perceived by consumers to be currently high, they may postpone consumption until the price drops to a level that is acceptable to them. Current macroeconomic trends indicate that this is not happening, but perceived inflation is also important for some other economic processes. For example, it often significantly affects financial markets. If an investor perceives inflation to be high, it may prompt them to invest in asset classes they consider to be an inflation hedge. An example is the real estate market, where citizens ‘store’ money wanting to beat inflation. This ultimately creates a bubble in the real estate market. This is one of the reasons for price inflation, but not the only reason.

Perceived inflation also affects workers’ demands for higher wages, which in theory can trigger an inflationary spiral. From a similar aspect, it is also important for the implementation of monetary policy. Perceptions are usually linked to expectations. If a critical mass of economic agents believes that prices will rise in the future, they will try to make purchases immediately, thereby actually increasing aggregate demand and creating pressure for future price increases. This type of self-fulfilling prophecy, in my opinion, can easily be seen in the real estate market in Croatia.

Do you expect further real growth in average net wages in Croatia this year, and to what extent? And how should this affect inflation, especially in conjunction with the effects of the upcoming tourist season?

I believe that a slight real growth in average wages, that is, at the aggregate level, will continue this year as I expect a gradual stabilization of inflation and a simultaneous increase in nominal wages in a relative amount slightly higher than the annual inflation rate. We are already seeing union pressure for wage increases in the public sector. Given the sensitivity of the political moment and the ruling party’s rating, which has not been this low since the pandemic, I think the government will do everything possible to prevent dissatisfaction and try to raise its rating. There is often public speculation that the dramatic increase in wages in the public sector during 2024 significantly contributed to inflation. However, recent research by Ozana Nadoveza points to different conclusions. The effect of wage growth in the public sector, although it concerned nearly 250,000 people, contributed to inflation by only 0.5 to 1 percentage points. Thus, without the price increase, inflation would have been 3.5 to 3 percent instead of the then four percent. Of course, that is not insignificant, but far from being the main contributor to overall inflation. Even when considering wage growth across the entire economy, HNB analysis shows that the effect on overall inflation in 2024 was moderate.

Regarding tourism and its impact on inflation, this is one of the usual theses that lacks much support in the data. My research with colleagues Kožić and Sever from the Institute for Tourism shows that the effect of tourist demand on inflation is practically negligible. This applies to both aggregate inflation and the price changes of subcategories of goods closely related to tourism – food and beverage prices, prices in restaurants and hotels, and recreation and culture. Croatia has been breaking records in the number of overnight stays and tourism revenues year after year, but for most of that time, inflation has been relatively stable. This means that we cannot blame tourism for inflation. We all have some anecdotal experiences where we see that prices of certain products and services rise during the summer months on the coast, but from the analyses conducted, I do not see that such an effect would exist at the level of the entire Croatia and for the entire observed basket of goods that enters the inflation calculation.

Do you think we are in an inflationary spiral that has gotten out of control? Considering the seasonality of consumption, the periodicity of elections for political power, and the continuous growth of tourism and its concentration in the summer months, how possible is it to mitigate inflation through macroeconomic measures aimed at consumption and wages?

I do not think we are in an inflationary spiral. Part of my generation may have thought that the economy as a science had advanced so much that we would no longer witness multi-digit inflation as our parents experienced several times during their lives. However, that was, of course, not realistic to expect. This is not about hyperinflation but about cyclical movements that are not so unusual. The problem is, of course, that Croatia is a small open economy, so any shock in the global market is felt more and stronger here than in larger and economically stronger countries. Approximately half of domestic inflation is a result of shocks in foreign markets, such as changes in the reference interest rate in the euro area, demand shocks from major foreign trade partners, and energy shocks in the global market. All domestic factors in the process of generating inflation are worth about the same. It is important to understand that economic processes are complex. Sometimes it is tempting to resort to simplifying reality and find a single ‘culprit’ for a particular economic problem, but reality is more complex than that.

Your question is directed at the short-term horizon, but I think it should be viewed at least in the medium term. Inflation is a very persistent ‘beast’. It takes a long time to cool down, but it seems to have deflated and is finally slowly settling down. Therefore, it may be important to offer a longer-term perspective. We can divide the answer to this question into two parts. The first is foreign. We are peripherally observing what is happening on the Ukrainian battlefield, but also how global powers will react to these processes. The European Commission proposed the ReArm Europe plan on March 6, 2025, which is supposed to direct 800 billion euros into the armament of EU member states from 2028 to 2034. Let’s think about what consequences this process will have on inflation within EU countries.

Also, it should be noted that economic growth and price stability are conflicting economic goals. That is why we are also listening to what decisions Christine Lagarde and the ECB will make in the future. Prompted by the stabilization of inflation in the euro area and the recession in Germany as its fiscal and developmental engine, the ECB has been continuously lowering reference interest rates since September 2024, thereby stimulating the growth of the economies of euro area countries. However, unlike those countries, Croatia still has significantly higher inflation, so further lowering interest rates would have an inflationary effect for us. Any misalignment in the business cycles between Croatia and the euro area puts us in a very unfavorable position. The sooner the euro economy recovers, the better for price stabilization in our market.

What about domestic factors?

Regarding domestic factors, as I have already mentioned, I do not believe that tourism and wage growth significantly contribute to inflation at the aggregate level. I fear that the issue is that we do not have enough domestic production to offer an adequate alternative to imported products. This is especially true in crisis conditions when strong self-sufficient states rely on their own production, primarily of food and energy. Secondly, I do not deal with the issue of market competition protection, but from the data, I see a fairly strong negative correlation between the degree of concentration in retail and inflation. Therefore, I believe there is room for a more active role of the Competition Protection Agency in maintaining price stability.

Thirdly, fiscal discipline is now a very important factor. Both as a buffer during times of crisis and as a stabilizer that, with responsible fiscal policy management, will not further fuel aggregate demand and create pressure on prices.

The HNB has made a certain contribution to solving the problem through tightening credit conditions that will come into effect on April 1, 2025. This is a macroprudential measure whose primary goal is the stability of the financial system, but it will also contribute to reducing inflationary pressures as a secondary effect.

Finally, economists globally have recognized the importance of disruptive technologies and technological progress in general in stabilizing inflation. Technology breaks down market barriers, increases competition in the market, boosts productivity, and ultimately affects the reduction of production costs, which then flows into the prices of final products. Long-term, this is the direction Croatia must take if it wants to achieve tangible and sustainable rates of economic growth, which will then help keep inflation under control.