Inflation expectations

 

Inflation expectations

Inflation expectations are the beliefs that households and firms have about future price increases. They are important because expectations about future price increases can affect current economic decisions that can influence actual inflation outcomes. For example, if firms expect future inflation to be higher and act on those beliefs, they may raise the prices of their goods and services at a faster rate. Similarly, if workers expect future inflation to be higher, they may demand higher wages to make up for the expected loss of their purchasing power. These behaviours, sometimes called ‘inflation psychology’, can contribute to a higher rate of actual inflation so that expectations about inflation become self-fulfilling.

Given that inflation expectations can influence actual price and wage setting, the extent to which inflation expectations are ‘anchored’ has implications for future inflation outcomes. For example, if households' and firms' expect that inflation will return to the central bank's inflation target at some point in the future, regardless of what current inflation is, we describe their expectations as being ‘anchored’ to the inflation target. When expectations are anchored, a period of higher inflation – perhaps resulting from a cost‑push event – will not cause households and firms to change their behaviour and, as a result, inflation is likely to eventually return to its target. But if the inflation psychology of households and firms shifts and inflation expectations move away from the central bank's inflation target (i.e. they become ‘unanchored’), a period of higher inflation will become persistent because households and firms will expect inflation to be higher in the future and adjust their behaviour accordingly. Consequently, it is much easier for a central bank to manage inflation if inflation expectations are anchored rather than unanchored.

Illustrative Example of Anchored and
Unanchored Inflation Expectations

‘Anchored’ inflation expectations

Inflation expectations over the longer run remain little changed in response to a period of higher inflation. Households and firms expect the increase in inflation to be temporary and do not change their behaviour, seeing the actual rate of inflation return to the central bank's inflation target.

‘Unanchored’ inflation expectations

Inflation expectations over the longer run move higher in response to a period of higher inflation. Households and firms adjust their behaviour as they expect the increase in inflation to be more persistent, eventually leading to a higher rate of actual inflation.

While inflation expectations have an important influence on actual inflation outcomes, they are not directly observable. Instead, policymakers such as the Reserve Bank have to rely on measures of expected inflation that are based on surveys (where people are asked their views about the inflation outlook directly) or financial assets like government bonds (where the price of the asset reflects assumptions made about the future path of inflation, see Explainer: Bonds and the Yield Curve).