Introduction

The Reserve Bank of Australia (RBA) has been commenting on the need to keep an eye on inflation expectations and inflation psychology in the current high inflation environment. In this Econosights we look at how inflation expectations have changed in Australia and what the implications are for interest rates.

Measuring inflation expectations

One of the biggest drivers of future inflation is current inflation because consumers and businesses make decisions around wage demands and product pricing based on current conditions. So inflation expectations reflect current conditions as well as some projection about future inflation. The recent rise in inflation expectations in Australia (along with the US and Europe) is not surprising, because price growth has been elevated for months. However, the concern for policymakers is whether short-term inflation expectations rise too much and if longer-term expectations move well above central banks inflation targets because it will be hard to bring expectations down without causing a recession.

There are a few ways to measure inflation expectations. Here I break them down into economist, consumer and market-based measures.

Australian economists expect inflation to remain manageable over the next 1-2 years (see the chart below) with inflation expected to fall back to 3.3% in a year’s time and 2.7% in 2-years time. This reflects expectations that current inflation drivers won’t persist forever (e.g. Australian flooding driving high food prices, gas supply issues and global supply chain problems) and are showing signs of easing, an expectation that the central bank will do what it takes to get inflation down to its 2-3% target band over the course of the business cycle and a belief that current interest rate hikes will be enough to get inflation down. Nevertheless, median economist inflation expectations for the next year look too low. We see inflation in a year’s time being around 4.5% (year on year).

Meanwhile, consumer inflation expectations are much higher than economists and have shot up recently , with 1-year ahead inflation expected to be 6.3% (the highest level since 2011) and 2-year ahead close at 6.0% – see the chart below.

These expectations reflect the current environment, with headline consumer prices up by 6.1% over the year to the June quarter – very close to consumer estimates for inflation in 1 and 2 years time. Consumers are assuming that the current inflation environment will continue unchanged. But this is unlikely as the forward looking indicators on inflation show that price growth should slow from here (commodity prices have fallen apart from gas, supply chain pressures are easing and supply related disruptions to fresh food from Australian flood will subside).

Consumer inflation expectations bounce around much more than economist expectations because they reflect changes in prices of volatile goods, particularly petrol prices – see the chart below. Recent declines in the oil price (WTI is down to $95/barrel from over $120 in May) could see some weakening in consumer inflation expectations if petrol prices in Australia start to fall.

Market-based measures of inflation are derived from instruments that hedge for inflation like break-even inflation rates and inflation linked swaps. The measure from inflation indexed swaps shows shorter-term expectations have drifted up to around 3% from 2.1% a year ago but longer-term 5-year plus expectations are still anchored at 2.5%, up slightly from 2.2% a year ago. This means that the market still believes in the RBA’s inflation target and doesn’t expect the high inflation environment to become permanent.

So the message from Australian inflation expectations is further upside in the short-term but to a level that is consistent with our own inflation projections and for longer-term inflation to settle back within the RBA’s 2-3% target band which means that the market still believes that the inflation target remains credible and achievable. Inflation expectations do not look unachored in Australia. For this to remain the case, the RBA has to sound committed to returning inflation to its 2-3% target.

US and Europe inflation expectations

Longer-term inflation expectations have been trending up in both the US and Europe. The initial June reading of the US 5-yr University of Michigan reading jumped to 3.3% (above the 2.5%-3% that it has been tracking at for the past 25 years) before declining to 3.1% in its final June reading (which occurred after the US Fed raised the Fed Funds rate by 0.75% which indicates that consumers expect a slowing in economic conditions as interest rates go up) and falling to 2.8% in July. Eurozone inflation expectations have also been trending up, with professional forecasters looking for long-term Euro inflation to average at just over 2%, its highest level since the survey began in 1999 (see the chart below). While expectations of 2% for long-term inflation are not concerning because this is the level targeted by the European Central Bank (ECB), the quick lift in expectations could worry policymakers, especially if there are further rises.

Implications for the RBA

Australia inflation expectations remain well anchored in the medium-term (despite the lift in short-term inflation expectations which reflects the current high inflation environment) which means that the RBA should not need to become overly aggressive in its settings of monetary policy in coming months, albeit it has to be seen to be defending its inflation target.

We expect that the peak in the cash rate for this cycle will reach around 2.6%. A higher level of the cash rate would likely cause too much downside for the economy as consumers will have to cut back spending signifcantly as housing costs lift (at a cash rate at 2.6% housing interest payments as a share of income will rise to over 8% (nearly a doubling from its recenty 4.4% level). Market pricing for a cash rate at 3.5% or above in a year’s time looks too high.