Inflation and its impact on consumer spending

By Nektarios Michail and Kyriacos Lambrias Since the outbreak of the war between US and Iran and the subsequent intermittent closure of the strait of Hormuz, ship crossings have been down around 90 per cent compared to pre-war levels causing oil prices to nearly double compared to 2025 levels. As a result, of these higher energy prices, inflation has increased, with the European Central Bank (ECB) June 2026 macroeconomic projections showing that Eurozone inflation is expected to average at 3 per cent over 2026, from 1.9 per cent in its December 2025 projections, with energy inflation revised to 8.4 per cent from -1 per cent in December. In this article we discuss the meaning of this expected increase in inflation for the consumer, looking at the various channels through which inflationary pressures affect consumer spending. Impact of inflation on consumersi The impact of rising inflation across consumers – and consequently potentially on inequality – depends on three main elements: the goods that are mostly affected, the saving and income patterns of different households along the wealth distribution, as well as the households´ balance sheet composition. The first one – called the expenditure channel – will affect different households disproportionately depending on the goods and services whose prices are increasing. This highlights the differences in spending when inflation does not refer to a generic, relatively homogeneous, increase in prices but when certain goods and services increase disproportionately, driving the overall price increase. As is well known, low-income households tend to spend a larger share of their income on necessities, such as food and energy. At the same time, the oil-driven nature of the current inflation increase combined with the particularities of the Cyprus economy and the energy dependence of the consumer – particularly for transport and electricity generation – suggest that such households are likely feel much higher inflation than the average. The income channel, on the other hand, describes the different impact of inflation on various households based on their main source of income. Low-income households’ main sources of income are wages and social benefits, which are typically slow to adjust, however, wage indexation practices, like the prevalent Cost of Living Adjustment (COLA), offer some protection. On the other hand, higher income households are more likely to have alternative income sources, like returns from financial investments and entrepreneurial activities, which can adjust faster to macroeconomic developments, like inflation, and at the same time offer more income diversification. Naturally, market-based adjustments are not necessarily favourable for investors, given that equity markets are notorious for their volatility. Yet, as high-income households tend to hold more financial assets, including shares in listed companies, whose profits which are usually stable in various macroeconomic environments, as observed in some previous inflationary episodes. Finally, the last channel – referred to as the wealth channel – has to do with the household’s balance sheets and is also linked with the income channel. Low-income households´ assets consist of primarily cash and bank deposits, whose real value is eroded by inflation. Yet, on the other hand, inflation lowers the real value of liabilities as well, such as mortgages, which are more likely to be held by low-income and young households. Thus, through this channel, inflation (especially unexpected inflation) redistributes wealth from lenders/savers to borrowers. The combination of the wealth and income channels can potentially benefit low-income households, if the real value of their lending decreases and the real value of their income remains the same through COLA-type adjustments. Potential impact on consumption patterns Whether inflation leads to lasting changes in consumption depends mainly on how long the shock lasts and whether it was anticipated. Temporary inflation shocks—and the temporary fall in real incomes that follows—generally do not create permanent shifts in spending. Consumers tend to smooth consumption across goods and over time, adjusting only until conditions stabilize. In the current environment, households are likely to reduce energy use and possibly cut broader spending or increase savings, but these effects should fade if inflation proves transitory. Two cautions matter, however. First, what counts as “temporary” is not perceived the same way by all consumers or firms. The Covid‑19 pandemic, while not a permanent shock like technological change, still produced lasting effects such as widespread hybrid work, which reshaped spending patterns. Second, very large shocks can trigger structural and enduring changes in consumption. A historical example is the 1970s energy crisis: the sharp fall in oil demand that followed contributed to the 1980s oil glut, pushing prices from a peak of $35 per barrel (about $137 in 2025 dollars) to below $10 by 1986 (about $29 in 2025 dollars). Concerning anticipation, when consumers anticipate rising prices, they tend to adjust their spending in advance. The challenge is that not everyone can accurately foresee price changes, and anticipation varies widely across households. As a simple way to measure unanticipated inflation, the chart referenced examines the residuals from a regression of inflation on its own lag. If inflation follows a random‑walk pattern, this month’s rate should be close to last month’s, producing small residuals. Unexpected shocks break this pattern. When inflation deviates sharply from its historical path, the gap between actual and predicted values widens, generating large positive or negative residuals. We treat any residual outside the 95 per cent confidence band (dashed line) as “unexpected inflation,” representing the top and bottom 5 per cent of deviations. Values within the band reflect inflation behaving as anticipated. The chart shows that in both 2022 and 2026, inflation moved well outside these bounds—clear signs of unanticipated surges. Economic research suggests that such surprises typically lead households to cut back on durable goods purchases, as uncertainty rises and real incomes become harder to predict. Chart: Inflation residuals Τhe 2022 experience in Cyprus showed that durables spending dropped to 3.8 per cent of GDP and remained at those levels over 2023 before returning to the average levels of slightly higher than 4 per cent in 2024 and 2025. Interestingly, this has also been the case in 2009 (spike in the middle of the chart), where an unexpected inflation increase pushed durable spending down to 5.9 per cent of GDP versus 7.7 per cent in the previous year. Naturally, whether something is anticipated or not as well as the subsequent consumer reaction, also depends on the ability to cope with a shock. As inflation was high in 2022, a new shock just four years later, and likely before some households have had time to adjust to the new price level, leaves consumers more vulnerable – especially those on the bottom percentiles of the income distribution. The duration of this inflation spike remains hinged on whether it is passed onto components which retain price increases for longer, such as services (and indirectly via wages). If this is the case, the inflation is likely to remain higher for longer and the effects on consumption and overall spending behaviour are likely to be more permanent. On the other hand, if the energy price shock is not passed on to the other components, or at least not to a major degree, then it is far more likely that the effects will be temporary. Table: ECB June 2026 Macroeconomic Projections (Source: ECB) The ECB now appears to have switched its view (table above), with inflation now expected to be above the 2 per cent target in 2027 as well, and with a pass-through to core inflation (i.e. inflation excluding energy and food prices), which is now expected to stand at 2.5 per cent for 2026 and 2027. Yet, the impact on growth is not expected to be high. On the other hand, more permanent effects are expected in the adverse and severe scenarios, something that is conditional on the duration of the oil price increase. In response to this, the policy response thus far, including the June rate hike, is reactive to this uncertainty and the possibility of a short-lived inflation increase, refraining from the continuous pace of rate hikes as in the 2022-2023 period. In conclusion, the effects of inflation on consumer spending will depend both on the duration of the inflationary shock and on how easily households can manage the new price increases, particularly those in the lower income levels. As households are currently adjusting to the new circumstances, the potential impacts on both the Cypriot and European economies are expected to become apparent later, depending also on the potential effects of changes in monetary policy. Nektarios Michail, Chief Economist, Bank of Cyprus. Kyriacos Lambrias, Economist, currently working as Risk Manager at UBS. Any views or opinions expressed herein are personal and may not reflect those of the authors’ employers. The article is republished from the Blog of the Cyprus Economic Society https://cypruseconomicsociety.org/blog/blog-posts/