Realized or Perceived Inflation? The Frequency Causality in the Formation of Expectation

Significant mismatches often present between realized and perceived inflation rates in the Euro Area, thus diverging their relationships with inflation expectations. This study clarifies the roles of realized and perceived inflation in the formation of inflation expectations in the Euro Area. The theoretical framework indicates that perceptions directly influence expectations through noticeable personal experiences and cognitive heuristics, while realized inflation dilutes this effect via statistical learning and dissonance reduction. Empirical evidence from frequency-domain Granger-causality tests shows that perceived inflation drives expectations across all time horizons, but its impact is diluted when realized inflation is taken into account. The dilution effect of realized inflation is more pronounced over longer horizons. These findings highlight the causal mechanisms underlying expectation formation, showing that consumers rely not only on official statistics but also on subjective perceptions, emphasizing the importance of managing inflation perceptions to guide long-term expectations.