RBA tackles inflation expectations in its latest analysis

These trends were discussed by the Reserve Bank of Australia (RBA) that discussed, unsurprisingly, why a low and stable inflation rate is a good thing for consumers.

“A low and stable inflation rate is critical to preserving macroeconomic stability. Having a good idea of what’s going to happen to prices allows businesses to plan for investment and expansion. It also makes things like budgeting and financial planning easier for households. This is particularly true for those on low incomes, who typically have smaller financial buffers than others and spend more of their income on essentials. And with more stable household and business balance sheets, the financial system is more stable,” said RBA assistant governor (economics) Sarah Hunter.

“The experience of the last few years has clearly highlighted this. Everyone across the economy has felt the increased cost of living. This is very clear in the data we monitor, such as household spending, but it’s perhaps more apparent in survey metrics such as consumer confidence, which remains much lower than its pre-pandemic average. So there are a number of good reasons to bring inflation down and keep it at a low and stable rate.”

The central bank said that while it’s important to keep a stable and low inflation rate, there needs to be a sense of realism applied to any situation, highlighting that expectations should “remain anchored.”

“So why do expectations matter at all when it comes to economic outcomes? We think they matter because people don’t just make decisions based on what is happening today, they also factor in what they think will happen tomorrow. In other words, inflation expectations are at least partly self-fulfilling,” Hunter said.

“For example, our decision over how much to save for retirement today is determined by how much income we think we’ll need once we stop working, and this is partly influenced by what we think will happen to prices between now and then.

“In addition to changing the behaviour of households, inflation expectations also directly feed into all of the decisions firms make – for example, over capital investment, pricing and staffing. One way this occurs is through the wage-setting process. This could be workers, or their union representatives, bargaining for higher wages if they think inflation will be higher. Or it could be firms’ expectations of higher future prices giving them the confidence to offer higher wages today to attract workers.”

According to Hunter, the expectations are what fuel long-term interest rates, exchange rates, and the prices of assets in our superannuation funds and all other investment portfolios: “In short, inflation expectations are a factor in pretty much every economic decision that’s made every day.”

The RBA said that “de-anchoring” expectations could do “enormous damage”. While the central bank isn’t currently concerned about a de-anchoring, it is on its radar. Hunter delved into how these expectations are formed:

• We estimate that around three-quarters of households and unions form their expectations by extrapolating from their lived experience. That is, they observe what inflation was yesterday and compare it to what they expected. Every time inflation turns out higher than what these people expected, they partially adjust their expectations up.
• This extrapolation process happens a lot slower for households than it does for unions. That is, households only adjust their expectations a small amount each time they are surprised. As a result, inflation has to be persistently higher or lower than previously expected for expectations to change significantly.
• The remaining one-quarter of unions and households don’t just extrapolate, they incorporate a lot more of the broader economic information available to them (beyond inflation outcomes themselves) to make forward-looking judgements about where inflation is likely to go. In principle, this is similar to the RBA’s forecasting process – we look at past outcomes and forward-looking indicators to assess how we think inflation will evolve from today.

Further to this, the concept of “salient prices” was examined. This is regarding the inflation of everyday products. This reportedly drives much of the consumer sentiment as the day-to-day purchases are growing in price rapidly, such as fuel, groceries, rent, and energy bills.

“Prices that change regularly or that people pay often may be particularly influential when people form their expectations – they’re more visible, and they could be seen as a proxy for what’s happening to all prices across the economy. These are known as salient prices,” Hunter said.

“From the beginning of 2021 until mid-2022, fuel price inflation was much higher than average price inflation, increasing 61 per cent over this period. But for most of the period since then, fuel price inflation has been around its historical average, while much of the broader consumption basket has continued to experience above-target price inflation.”

Some of the major takeaways from the RBA’s research were:

• People appear to associate high inflation with worse economic conditions, but higher wages growth with better conditions.
• The relationship between current wage expectations and inflation expectations is relatively weak.
• Estimated monetary policy shocks have a limited effect on expectations despite affecting actual inflation, while oil price shocks tend to move inflation and real wage expectations in different directions.
• Inflation expectations appear to be based a bit more heavily on past conditions, while wage expectations appear to be based more on future conditions.
• Households appear to have looked through the recent transitory spike in inflation more than we might have expected based on past behaviour and so expectations have come back down more quickly. This may reflect, in part, the RBA’s efforts to communicate the transitory nature of the shock.
• Households’ inflation expectations appear to be particularly sensitive to petrol prices, beyond what might be predicted given petrol’s share of households’ consumption.

Related: RBA weighs out considerations for hike or cut

Jack Campbell is the editor of Broker Daily. After graduating from the University of Wollongong in 2022, Jack began his journalistic career working on Broker Daily’s sister brand, HR Leader. In August 2023 he was made the news editor and worked alongside some talented journalists writing articles and recording podcasts.

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